U.S. downgrade hurts other bond classes

Debt Crisis Update

U.S. debt: Not off the hook yet

Obama signs debt deal, default averted

Despite its resolution, the U.S. debt crisis has dampened investor mood and battered the U.S. financial markets. Fear continues to stalk various asset classes across the board, none more so than municipal and state bonds.

The proposed spending cuts at the centre of the debt deal could leave state and local governments facing unprecedented budgetary challenges.

While a lack of federal funding is a valid concern, it’s the threat of potential rating downgrade that has market participants battening down the hatches.

“If the U.S. gets downgraded, there could be some blowback effect on certain particularly vulnerable states and municipalities,” says Jack Ablin, chief investment officer at Harris Private Bank.

Moody’s Investors Service recently put five U.S. states—Maryland, South Carolina, New Mexico, Tennessee and Virginia—under review for a possible rating downgrade because of their reliance on the federal government. For these states, caught in the ratings crossfire, downgrades would mean higher borrowing costs.

Even raising the U.S. debt ceiling may not diminish the potential for downgrades as rating agencies can downgrade U.S. debt depending on short-term and long-term details of budget agreements.

Ablin said cities and towns were already struggling before the debt ceiling issue. “It’s related to what level of support we can expect from Washington. Given their own problems, it seems that [Washington] doesn’t have the flexibly to spend at the state [and] local level anymore,” he says.

Those holding municipal and state bonds could be looking at a potential haircut, he says, adding “right now, most muni bonds are pretty high credit quality so I wouldn’t expect necessarily a haircut unless [investors] sell their bonds before maturity.”

Another worry that currently plagues cities and states is that the federal tax exemption for newly issued municipal bonds could be eliminated, making borrowing more expensive. Currently, a municipal bond is exempt from federal income tax, and can be exempt from state tax, depending on the investor’s residency.

“That certainly would be disastrous for municipal bonds, but I don’t see that happening,” says Ablin. “I wouldn’t worry so much about losing the tax exemption. What I’d worry about if we moved, and it would appear we probably will, to a lower tax rate with fewer loopholes; that would hurt muni bonds.”

The issue of federal tax exemption, of course, doesn’t concern Canadian nationals who don’t enjoy the tax benefits of muni bonds, which are favoured largely by those looking for a safe way to diversify their portfolio.

From an investor perspective, there are very few alternatives to muni and state bonds. “Investors may not like what’s going on in Washington, [but] there are very few other safe alternatives worldwide,” Ablin says.

However, Ablin warns that “one of the things investors have to keep in mind is that any one who buys a 10-year Treasury today is locking in a yield that is at the rate of inflation. They are essentially locking in no purchasing power. And anyone who buys a five-year bond is actually locking in a negative rate of return.”

Investors seeking diversification “would probably start with an ETF or a muni fund and have a smattering of high quality and even a small mixture of low quality because of the incremental yield involved.”