Debt downgrade threatens muni bonds

Having narrowly escaped the U.S. debt default blow, the holders of municipal and state bonds were only beginning to breathe easy when the credit rating downgrade rekindled their worst fears. A haircut for these investors may now be inescapable as state and local governments brace for unprecedented budgetary challenges.

There could be some blowback on certain, particularly vulnerable, states and municipalities, says Jack Ablin, chief investment officer at Harris Private Bank.

“I think the downgrade is really going to drive a wedge between those municipal credits that rely on the federal government for support versus those that can stand on their own,” says Ablin. “So, for example, S&P [Standard & Poor’s] right now is in the process of downgrading municipal credits where that heavy reliance lies on the government.”

Similar sentiments were expressed by Chris Mauro, director of municipal bond research at RBC Capital Markets RBC.

“These muni rating changes will consist almost entirely of municipal bonds ‘directly linked’ to the federal government,” says Mauro.

This category includes pre-refunded bonds escrowed with U.S. treasuries, public housing agency bonds backed by federal agencies, and limited transportation and other special revenue bonds secured by payments from the federal government.

Municipals on the other side of that wedge are expected to escape unscathed. “Self-supporting, self-sustaining obligations like an essential service revenue bond where they’re drawing their debt payments from the revenue source at hand, like water and sewer, some sort of a usage-fee type of programme” will remain insulated and independent from the vagaries of Washington, says Ablin, adding that being on the wrong side of that wedge is not all that hopeless.

“It’s just that it’s not the belt-and-suspenders credit that perhaps investors had assumed,” he continues.

The $2.9-trillion municipal bond market contains about 1.2 million individual CUSIPs (Committee on Uniform Security Identification Procedures). These numbers worry Mauro, who anticipates that “most media outlets will run with numbers that could be deceiving.”

“As a result, S&P’s anticipated downgrade of pre-refunded municipal bonds and other directly linked bonds will, in the aggregate, produce a very attention-getting headline number,” says Mauro. “Our immediate concern is that these kinds of headlines will prompt retail investors to engage in another wave of mutual fund selling.”

But there’s something else that is looming out there for munis and state bonds. “It seems to me,” says Ablin, “the way Congress is going to raise revenue is by lowering the [tax] rate and broadening the base, lowering the rate and getting rid of loopholes. Generally speaking, that’s a negative for muni bonds.”

Lower tax rates, while generally preferable for investors, would eliminate some of the appeal of munis, as the interest payments are tax-free.

Ablin concedes “there are a couple of clouds on the horizon,” but his outlook continues to be “sunny.”

He adds a word of caution for investors. “If 2008 didn’t drive home the message, then 2011 should, and that is that muni bond buyers need to do their own credit research; they can’t rely on their broker and credit rating agencies to do that work for them.”

Investors may not like what’s going on in Washington, but there are very few other safe alternatives worldwide, he says.

“That’s the irony of the whole thing; notwithstanding the downgrade, Treasury bonds actually rallied through this downturn, and that underscores the fact that in terms of a demand and supply balance, there is just a huge supply of savings and cash looking for high-quality safe haven assets, and there are few safe haven assets.”

Treasuries, therefore, represent one of the safest places to invest relative to its peers—even after the downgrade, he adds.