The US Downgrade and the Muni Bonds

We have fielded many questions in the last few days about what effect the downgrade of the United States debt from AAA to AA+ and the effect on the 11,000 or so municipal bonds that S&P subsequently downgraded. Investors and professionals want to know what they should do with the muin bond portfolios.

The bonds that may be effected most include Housing bonds (bonds with 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 may see their ratings downgraded, depending on the proportion that the federal government is responsible for on the leases

Pre refunded and escrowed municipal bonds, the gold standard for munis: 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. Investors will continue to own prerefunded bonds in the shorter-maturity end of a barbell strategy.

It is important to remember that both Moody’s and Fitch continue to rate the US as “AAA” including housing bonds backed by the federal government or prerefunded bonds or bonds backed by federal leases. As strange as it sounds, because state and local governments and their agencies are rated on different criteria than governments, some municipal issuers will have S&P credit ratings higher than the federal government.

The smart muni bond professionals who fly in our circle are saying the municipal marketplace will still react to the same forces it has in the past: high demand for tax free bonds propping up prices due to low supply, retail buy and hold investors ignoring much of the fray, bond fund redemptions of high quality bonds causing a pricing ripple effect on on all other muni bonds and the lack of clear insight into the why and how of credit ratings.