The US Downgrade and the Muni Bond Market
August 10, 2011
The downgrade of the United States from AAA to AA+ this weekend affects a number of municipal bonds – more than 11,000. They fall broadly into several categories:
Housing bonds (bonds that enjoy the backing of federal agencies like GNMA and FNMA) will see their S&P ratings affected.
Certain lease bonds with the federal government as a tenant will see their ratings downgraded, depending on the proportion that the federal government is responsible for on the leases
Prerefunded and escrowed municipal bonds: These are generally older, higher-coupon bonds that have been defeased by their issuers. Proceeds of “refunding” issues are placed in Treasury securities to pay interest and call the older bonds at the first call date. This results in significant cost savings for the municipalities, and the older bonds are often (but not always) re-rated AAA based on the US Treasuries, which are now backing the older bonds. These bonds will see a downgrade.
What does this mean from a portfolio-management sense? In our view, it should not affect the muni market greatly. In our opinion, the United States is still the premier sovereign credit in the world. We will continue to own prerefunded bonds in the shorter-maturity end of our barbell strategy, and we believe that state housing agencies offer some of the best value in the municipal marketplace.
The charts below compare the prerefunded municipal bond scale, with the Municipal Market Advisors AAA scale on August 1st and then on August 8th – after the passing of the debt ceiling, but just before the S&P downgrade of the US (though in the marketplace that was a given). There was no budge in scale.
It is important to remember that both Moody’s and Fitch continue to rate the US as “AAA.” Thus those ratings are still in place on housing bonds backed by the federal government or prerefunded bonds or bonds backed by federal leases.
Because state and local governments and their agencies are rated on different criteria than sovereign governments, it is likely that a number of high-grade municipal issuers will have S&P credit ratings higher than that of the federal government.
In total, in our opinion, the municipal marketplace will still react to the same forces it has in the past: demand for tax-exempt interest, flows in and out of municipal bond funds, and perception of credit on an individual credit basis.
8/1/2011 Pre-Re MMA – AAA
8/8/2011 Pre-Re MMA – AAA
John Mousseau, CFA, Managing Director and Portfolio Manager
John Mousseau is a portfolio manager and heads the tax-free Muni section of Cumberland. He is a member of the Management Committee of Cumberland Advisors. His bio is found at www.cumber.com. His email is John.Mousseau@cumber.com