US Downgrade – A Municipal Market Perspective

The downgrade of the US Government by S&P from AAA to AA+ has mixed implications for the municipal market.  In the short run, the downgrade is mostly symbolic, and while a “yawner” at this point, it is a symbol of a longer term concern that could have broad implications (positive or negative) for the municipal market.

 Short-Term Implications:
In the short-term, the impact on the municipal market will be defined by credit ratings changes as issuers are systematically downgraded.  Moody’s has estimated that it has over 7,000 municipal issuers that are related to the US Government.  This represents less than 10% of the over 80,000 issuers in the municipal market.  The impact on bonds will be variable; some bonds will be unaffected.  More specifically:

Bond Type

Impact

Discussion

General Obligation
(GO)

 It will be hard to justify any state GO pledge being higher ranked than the pledge of the US Government.  States currently rated AAA are at risk to be downgraded to AA+. Those states that are more dependent on federal aid will be downgraded first.  If AAA rated municipal bonds are no longer AAA, then what about the AA+?  Are they now AA?  Where this trickle down stops is not known.  It is now S&P’s “repealing the recalibration” of the municipal credit quality scale that what was done in 2010. Impact on the credit trend and market pricing was mute then, and will be now. 
Municipal bonds with US Government and/or agency
backing

 Will be downgraded to reflect their current status in the Government-sponsored food chain :

  • Prerefunded – Downgraded from AAA to AA+
  • Escrowed – Downgraded from AAA to AA+
  • GNMA/FNMA/FHLMC- Downgraded from AAA to AA+
  • FHA Backed – This is less obvious, as the current rating of AA reflects the US Government AAA pledge, combined with the “potential” delay in full repayment.  Ratings could go to AA-.

 

Essential Service Revenue Bonds

 The case for credit quality strength gets stronger.  Bonds backed by a dedicated revenue stream derived from fees for services, such as water and sewer, and electric utilities, should remain unaffected. 
Municipal bonds backed by a dedicated source of tax revenues

None

 Credit quality of bonds backed by a dedicated source of tax revenues (i.e. sales tax) are expected to be unaffected.  Likewise, ratings will be unaffected. 


 
The short-term credit rating impacts are not material, and do not change our view that fiscal restraint, policy changes, and an improving tax revenue picture has municipal credit quality on an upswing.  

 Long-Term Implications:
Long-term, the US Government’s fiscal imbalance has created issues that could have major implications on municipal bonds. The downgrade of the US Government came about due to excess spending and the US budgetary imbalance.  How Congress and The White House choose to deal with this fiscal imbalance will significantly define the future municipal market: 

  • Targeted cuts on spending that decrease subsidies or other aid to municipalities will increase fiscal pressures on issuers that create long term credit quality challenges.
  • Market access becomes constrained or altered.  There is some concern that municipalities will no longer be able to issue tax-exempt debt because the US Government will try to recover interest income from tax-exempt bond issuance. Coupled with constraints placed on other financing options (Build America Bonds, variable rate demand bonds), this will drive up the cost of debt issuance.
  • If income tax rates on the wealthy are increased to provide additional revenue and market access is not constrained, the demand and value for tax-exempt municipal bonds will also increase.

 Conclusion: 
We have been, and continue to be, a strong advocate of essential service revenue bonds.  These bonds should remain a strong investment where the priority is principal protection.  If there is a decrease in prices, due to a sell-off in the municipal market from credit concerns brought on by the downgrade of the US Government, bond opportunities may become available at the right price.  For the long term, the politicians’ “pool party” in Washington is just beginning; we will see what they put in the punch.

                                                                                                                                 

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Posted in Economic theories, General, Munis in the news, Taxes

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