S&P’s decision to lower its longterm sovereign credit rating on the U.S. to AA+ with a negative outlook was a surprise to many, and now it’s affecting a range of municipal bonds with direct links to the federal government. As of August 8, 2011, S&P has downgraded over 3,000 bonds it deems directly linked to the sovereign credit rating: defeased bonds, or those bonds that have been “pre-refunded” and are being repaid by certain Treasury investments; muni housing bonds backed by the federal government; bonds of government-related entities such as the Tennessee Valley Authority; and bonds secured by federal leases.
Looking more broadly, we believe the implications from the U.S. government downgrade as well as the overall environment make a good case for muni investors to prefer essential-service revenue bonds over General Obligation (GO) securities. Simply put, there is less uncertainty over bonds backed by relatively inelastic revenue streams.
There may well be additional muni downgrades that result from the sovereign ratings action, though the backloaded nature of the deficit cuts and other unknowns from the debt-ceiling deal make it unlikely that additional widespread municipal ratings action will occur at this time. S&P said in a July 21 report that after receiving additional clarity on the deficit-reduction plan it will look at the balance of cuts that target individuals (e.g. Social Security) and those that focus on the government and institutions (e.g. Medicaid and grants).
Keep in mind this is not the first time that we have seen the muni market face potential ratings downgrades. During the 2008 financial crisis, many muni bonds lost their AAA ratings when wrap insurers could no longer provide a AAA guarantee. Therefore the muni market has become a market where credit analysis is increasingly important. In the current environment, federal funding levels are a key aspect of credit analysis, and bonds with revenues that are closely linked to the U.S. government will have a higher probability of being downgraded.
We refer to the July report from S&P in which the ratings agency described three hypothetical scenarios to gauge how U.S. public finance credits might be affected by federal action on the debt ceiling and budget deficit. We believe S&P views last week’s events and the fiscal consolidation plan as most closely resembling the second of three hypothetical scenarios the ratings agency put forth, specifically: “Hypothetical Scenario 2: Agreement to Raise the Debt Ceiling But No Credible Agreement to Reduce Debt.” (The other scenarios included the optimistic outcome of raising the ceiling while truly reducing debt as well as the “specter” of default.)
S&P noted that Scenario 2 is the least disruptive in the short term for municipal issuers, because an immediate U.S. default and dramatic federal funding cuts are avoided. Excluding bonds with direct links to the U.S. government as described above, we don’t anticipate additional wholesale downgrades in any municipal sector. Nonetheless, issuers with significant indirect exposure to the federal government may experience downgrades.