The U.S. municipal market could prove more resilient than feared in the face of Standard & Poor's historic downgrade of the U.S. credit rating, analysts said.
Two positive factors give the market a shot at hanging onto last week's sparkling gains, when yields on some top quality bonds tumbled as much as 40 basis points: the lack of supply and the safe-haven bid for Treasuries.
"It's so hard to predict, but I don't foresee this announcement by S&P as being a catalyst for selling," said Robert Nelson, managing analyst for Municipal Market Data, which is part of Thomson Reuters.
"The possibility of this downgrade was already known to this marketplace as it traded up so aggressively last week," he said.
Though the municipal market only partly shared the Treasury market's extraordinary rally, analysts say the tax-free market is getting some safe-haven buying from investors unnerved by the stock market's plunge last week.
On Monday, Standard & Poor's is expected to downgrade the ratings of pre-refunded municipal bonds, U.S. mortgage agencies and other credits tied tightly to the federal government. Late Friday, S&P cut the country's credit rating to "AA-plus" from "AAA" and gave a negative outlook to the long-term rating.
Perhaps the downgrading of the U.S. rating might have had more impact on municipals in previous years, when there was a bit of an expectation that the U.S. federal government might ride to the rescue of beleaguered states or cities.
"I think we've heard from a number of officials in the federal government, and I think that at the same time the federal government is not in any position to to bail out states, so in the muni market I think most recognize that the notion of the federal government as a backstop has been pretty largely discounted," Nelson said.
The immediate market impact of the U.S. credit downgrade might be somewhat muted by the tax-free market's traditional strengths.
Many of the tens of thousands of tax-free issuers, from states to counties and schools, raise revenue from their own taxes and fees, independently of the federal government. The default rate historically has been under 1 percent.
"I don't see a tremendous flight out of municipals; you might see credit spreads widening for lower-rated issues, but we also think a lot will hold their ratings," said Evan Rourke, a portfolio manager with Eaton Vance in New York.
"Our feeling is that you can still have an AAA-rated credit ... you could have AAA-rated credits in an AA-plus-rated country," he said.
S&P still rates 13 U.S. states at AAA.
Michael Pietronico, chief investment officer for Miller Tabak Asset Management in New York, said: "If there is going to be any reaction to this downgrade, it's going to be in pre-refunded securities, because investors buy them for the federal backing."
S&P is expected to immediately downgrade so-called pre-refunded bonds. When municipal bonds are refunded, investors typically are repaid from Treasuries held in escrow.
Referring to pre-refunded bonds, Pietronico said: "It's still an excellent credit and it is just likely to be a little less liquid than usual."
Next on the list of the most at-risk municipal credits is the billions of dollars of debt issued by public housing authorities secured by federally guaranteed mortgages.
S&P is expected to downgrade Fannie Mae and Freddie Mac, the two main government-sponsored enterprises (GSEs) used by state or local public housing authorities. Any defeased bonds backed by U.S. agency securities would also be considered vulnerable.
Debt issued by AAA-rated universities and colleges with global reputations might rise in price, Rourke said, citing Harvard and Princeton universities as examples.
"They have global appeal and extensive pricing power; they might actually go up in price," he added.
Perhaps the biggest long-term threat to muni credits is the possibility that the federal budget will be cut more deeply.
"The anticipation is that the lawmakers in Congress will react to this downgrade by cutting more spending," said Miller Tabak's Pietronico.
"If they fail to react to this downgrade by cutting spending, there should be very little impact on municipalities; this is going to take time to play out," he said.
States that rely heavily on government spending -- such as Virginia and Maryland, which are home to many federal employees and defense contractors -- could suffer, he said.
States, counties, cities, hospitals, schools and the like might have to borrow more to make up for cutbacks in federal programs, analysts say. But hospital credits could be weakened if the federal government slashes health-care programs.
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