How S&P Downgrade May Impact the Municipal Bond Market

The fallout from the S&P downgrade of U.S. debt from AAA to AA+ is just starting to hit the municipal market. Following the downgrade of U.S. debt on Friday, S&P has begun to review and downgrade the debt of AAA rated cities and towns. Bloomberg reported that:

"S&P downgraded to AA+ from AAA debt backed by federal leases and sold by issuers including Tacoma, Washington; Miami, Florida; the Atlanta Downtown Development Authority and the Board of Governors of the University of North Carolina, the ratings company said in a statement.

'They were downgraded in lockstep with the sovereign,' Olayinka Fadahunsi, a spokesman for S&P's public finance division, said in a telephone interview."

In a confernece call John Chambers head of S&P’s sovereign ratings committee said “We said we would be looking carefully at some of the indirect effects, if you like, on possible fiscal consolidation programs in Washington as they might impact the budgetary decisions of state and local governments.”

As S&P continues to evaluate cities and states, this will result in hundreds of downgrades. Municipal governments that rely on government funding or have their bonds federally backed stand a good chance to be downgraded.

Despite the downgrade, muni yields have droppped along with Treasuries, hardly a sign of short-term investor concern. But longer-term, downgrades could indirectly increase borrowing rates for municipalities. I suspect the ratings downgrade will accelerate and deepen federal cuts to states and cities, putting more pressure on cash-strapped municipal and local governments. How these governments respond to these challenges should determine their ratings going forward. To me, this cut in state and local aid is the biggest long-term risk to munis.

As a muni investor, it's unlikely that a downgrade from AAA to AA+ alone will significantly increase the risk of default. Munis rarely default. If interest rates rise, than the value of existing munis may fall. But a downgrade may also provide more yield for investors. How states and cities react to less government support will help determine what happens to future muni yield and pricing.

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