Fitch downgrades of munis tied to U.S. rating to have little impact on market

Bonds

Following Fitch Ratings downgrading the U.S. sovereign rating to AA-plus from AAA, the rating agency has downgraded certain municipal bonds tied directly to the creditworthiness of the country. Despite this, market participants say the muni market will see little impact.

The bonds affected are “pre-refunded bonds whose repayments are wholly dependent on ‘AA+’-rated United States government and agency obligations held in escrow; housing bonds that are primarily secured by mortgage-backed securities issued by Ginnie Mae, Fannie Mae and/or Freddie Mac; and obligations that are supported by credit enhancement issued by financial institutions directly linked to the United States, such as Fannie Mae or Freddie Mac,” a Fitch press release said.

In addition, two bonds where the letter of credit was provided by the Federal Home Loan Banks of Atlanta have been downgraded by Fitch. 

“Every time we’ve rated [these bonds], we have pointed out that there is this dependency on the U.S. rating,” said Arlene Bohner, head of Fitch’s U.S. public finance department.  

“So, when our sovereign team put it on watch, we had to put ours on watch,” she continued. “When they lowered the ratings, we had to lower our ratings.”

CreditSights’ Pat Luby said the downgrades may lead some participants “to be sniffing around for bargains if there are a few investors who sell on the rating changes.”

BofA strategists said it will be a “relatively small figure” of debt.

They said it includes $3.5 billion of pre-refunded bonds, $1.8 billion of housing bonds and less than $50 million of bonds with letters of credit from the Federal Home Loan Banks of Atlanta and Des Moines. In addition, there is nearly $20 billion of Tennessee Valley Authority, the nation’s largest public utility, corporate CUSIP debt outstanding, per Fitch..

“The limited scope of muni debt affected suggests a marginal impact on the muni market, if any,” BofA strategists said.

“For the most part, we do not see the muni market being affected by this downgrade in a significant way,” said Barclays strategists Mikhail Foux, Clare Pickering and Mayur Patel following Fitch downgrading the U.S. credit.

James Pruskowski, chief investment officer at 16Rock Asset Management, said the muni market, like the broader economy, is strong, and the downgrades are unlikely to have much of an impact.

“Albeit it, we’re at peak rating cycle and rainy day funds at record reserves certainly put us in a much better position than past crises or risks thereof,” he said.

The downgrade of select bonds came as little surprise to market participants.

The affected munis have a direct relationship to the federal government, so the downgrades were expected, said Tom Kozlik, managing director and head of public policy and municipal strategy at Hilltop Securities.

“None of this strikes me as surprising,” said Pat Luby, a CreditSights strategist. “I don’t think market participants will make any changes in their portfolios or strategies as a result of it.”

While the ratings on certain bonds have been downgraded, he said the fundamental strength of the credits remains strong.

The downgrade of certain muni bonds will do little to move the market, Luby said.

This is especially true for pre-refunding bonds, as there is not an abundant supply. Furthermore, if the market were to cheapen on pre-funding bonds, he said there would be “amplifiers” stepping in.

If anything, he said this could encourage more people “to be sniffing around for bargains if there are a few investors who sell on the rating changes.”

Kurt van Kuller, a portfolio manager at Sit Investment Associates, said one of the impacts of the downgrades is munis may look better than corporates and Treasuries, potentially enhancing demand for certain munis.

“That is, during future flights to quality by investors, certain municipal bonds may be viewed now as havens,” he said as investors recognize “the strengths of strong municipal credit and regard them as potentially more of something they should hold or seek for safety.”

He said the three rating agencies have given around a dozen states, including Florida and Texas, AAA ratings, which he said “are apparently deemed more creditworthy than the federal government.”

“Perhaps this distinction will become more meaningful if current trends continue,” van Kuller said.

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