Muni-Friendly Comments Give Market a Push

Higher borrowing costs for state and local governments as a result of the sovereign downgrade? Hardly. Or at least: not yet.

Muni investors reacted with open wallets Wednesday upon hearing more supporting statements for public finance credits from rating agencies amid the maddening volatility.

Moody’s Investors Service released a special comment suggesting municipal issuers are “well-insulated” during the turmoil, as most issuers are not dependent on market access for critical funding requirements.

“The vast majority of these issuers could successfully manage through a period of diminished market access and tight liquidity without facing a severe deterioration in their credit,” the agency said.

Unlike corporate or sovereign debt, municipal debt tends to be fully amortizing with payments included in operating budgets, so issuers need not rely on market access to roll over principal maturities, Moody’s added.

Standard & Poor’s continued to defend the idea of top-quality muni credits outranking the sovereign “ceiling” and confirmed that no more rating actions would be taken in the near term on state and local credits owing to their downgrade of the U.S. sovereign last Friday.

Instead, a full review of all public finance credits would be undertaken once Congress clarifies what expenditure reductions will be taken over the coming decade. The 12-member joint committee established by Congress is scheduled to release its findings Nov. 23; a vote is scheduled Dec. 23.

“Most credit implications, we feel, will be linked to federal spending actions,” analyst Steve Murphy said on a conference call Wednesday morning.

Standard & Poor’s needs to hear specifics on federal expenditure cuts including how much, where, what types, and over what time frame.

“After we have these facts, we’ll assess the impact on public finance credits,” Murphy said, adding that the agency will look at the impact from macro and micro perspectives. “And I’m not just talking about the AAA’s here, I’m talking about all our credits on a case-by-case basis.”

Since Friday, Standard & Poor’s has downgraded more than 12,000 muni bond issues concentrated in specific sectors connected to the United States’ credit ratings.

Tuesday’s bond-friendly outlook from the Federal Reserve also helped the case for snapping up munis, according to Duane McAllister, portfolio manager for the Marshall Intermediate Tax-Free Fund at M&I Investments.

A simple calculation between holding cash and moving out the muni bond yield curve should convince investors of the value munis hold, at minimal risk, he said.

“The Fed is pretty clear they are holding rates for two years and possibly adopting more bond-friendly policies, so suddenly the intermediate part of the curve looks appealing,” McAllister added. “It didn’t, prior to this. Even though nobody was expecting the Fed to move any time soon, the clarity of that has given us some further guidance.”

The Standard & Poor’s webinar also cleared up rating doubts about Build America Bonds, the taxable munis backed by a 35% interest cost subsidy from the federal government.

The downgrade of the sovereign was too insignificant to warrant a rating change on any BABs, the agency said.

“Even in the event of a subsidy payment default, the issuer is liable for the debt service payments,” George Friedlander, chief muni strategist at Citi, noted before the webinar in a report published Tuesday evening. “Issuer distress was more of a worry when the debt ceiling negotiations were in play, as the possibility of a delay in federal payment was possible in case of a federal shutdown.”

The added certainty prompted investors to dive into the muni market after two relatively quiet sessions that, ignoring intraday volatility, left the muni curve unchanged in the first two days of the week.

Tax-exempt yields dove to new depths for 2011 on Wednesday with the benchmark 10-year yield finishing 12 basis points lower at 2.26%, its lowest yield since Sept. 3, 2010, according to Municipal Market Data.

Appetite for intermediate-term paper helped the two-year to 10-year spread flatten to just 196 basis points, its lowest since October 2010. The 2011 median spread is 236 basis points.

BABs were mopped up too. An average yield index governed by Wells Fargo, going by the ticker BABSAY, showed yields drop Tuesday to 5.06%, its lowest yield since inception last November.

BABs have underperformend Treasuries though, so they continue to offer value. The spread between the BABSAY index and the 30-year Treasury was 151 basis points Tuesday, five basis points wider than its 2011 mean.

Mikhail Foux, director of credit, derivatives and muni strategy at Citi, said to view such numbers with caution.

“It’s the same thing with corporates — there has not been much trading,” he said in an interview, adding that a 15 to 20 basis point move might be an exaggeration.

From Aug. 1 to Aug. 8, BABSAY jumped back and forth by at least 10 basis points per day.

“The economic situation continues to deteriorate, the European sovereign situation has not been resolved, so I’d expect quite a bit of volatility still,” Foux said. “Stick to high-quality BABs, something like universities that don’t rely on federal research grants or revenue bonds. They have outperformed and should continue to outperform.”

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