State and local governments have been making the right choices recently to balance their budgets, but downgrades could increase in 2011 as a result of slow economic progress, according to Standard & Poor’s.
“Notable ratings downgrades, specific instances of severe fiscal problems, and a generally softer environment for municipal credit could occur,” primary analyst Gabriel Petek wrote in a report published Monday.
Standard & Poor’s downgraded 391 borrowers in the public finance market in the first three quarters of 2010, including 343 state and local governments. Full-year data is not yet available, but those figures already outnumber the 368 downgrades in 2009, of which 273 were state and local governments.
The agency, which rates 17,500 of the 60,000-issuer muni-verse, predicts the number of defaults “will remain mostly stable with the possibility for a modest uptick” this year. It forecasts the majority of issuers are likely to “retain solidly medium-to-high investment-grade ratings.”
According to Tom Doe, chief executive at Municipal Market Advisors, there were 256 defaults in 2010 amounting to $8 billion. Only 15 had initial ratings from one of the three main rating agencies.
Standard & Poor’s commends local governments for making difficult policy choices to balance budgets. But it said the economy will likely grow at a 3% pace in 2011, versus the average 5% rate in the previous eight recoveries from a recession.
“Even if a more robust economic recovery takes hold, we expect that state and local government revenues may continue to demonstrate a muted response to the recovery owing to reduced federal aid and the expiration of previously adopted temporary tax increases,” Petek wrote.
The agency was even less bullish on unrated debt, which includes land-backed bonds that are typically repaid from property assessments in a residential development, often for incomplete projects.
“Unrated debt issued for incomplete property developments may, as in recent years, continue to exhibit higher rates of distress,” Standard & Poor’s said.
The report warns about local government debt intended to finance projects not directly related to core services.
It also cautions that some governments may attempt to avoid difficult decisions by underfunding contributions to pension systems rather than cutting public safety services, which could erode the long-term credit strength of an issuer.
However, such decisions would also indicate a strong capacity to meet debt obligations, and Standard & Poor’s believes most issuers will retain that willingness to maintain access to future investors.
“A defaulted debt-service payment would likely result in a loss of access to the capital markets, which has predominantly been the source of funding for capital and infrastructure projects,” Petek noted.
As for the expiration of Build America Bonds, Standard & Poor’s said the non-extension of the program should have a limited credit impact. The agency said the program broadened the investor base of municipal finance but had little bearing on the credit quality of issuers.
Some analysts attributed the jump in borrowing rates at the end of last year to the expiration of the BAB program, but Standard & Poor’s said it is more likely that municipal rates were merely tracking the Treasury market.
