‘Superdowngrades’ could sink munis

A dramatic increase in the number of “superdowngrades” could wallop the municipal bond market this year, muni experts predict.

They believe that the number of such double- or triple-tier declines in credit ratings could jump from the typical one or two per year to dozens as ratings agencies comply with Dodd-Frank’s demands for more-intense scrutiny of issuers and as municipal bond insurance becomes less common.

Before the financial crisis, nearly half of all municipal bonds were insured. Now, because the price of such insurance has soared, only about 6% to 10% of munis are insured, said Patrick Early, chief municipal analyst at Wells Fargo Advisors. Absent insurers’ guarantees, ratings agencies now must vet issuers more diligently, and they’re playing catch-up, he said.

“It really underscores that you need to know what you own,” said Tao Chen, vice president and municipal bond strategist at investment manager Payden & Rygel. “The ratings agencies are stepping up their game.”

Peter Hayes, head of municipals at BlackRock Inc., said the extra scrutiny is in part the result of a provision in the Dodd-Frank legislation that requires ratings agencies to review their methodology at least once a year.

“They’re starting to look at different criteria than in the past,” Mr. Hayes told attendees at an Investment Management Consultants Association conference in New York last week.

The frequency of muni audits is getting more attention, as well as financial disclosure, he said.

Superdowngrades could be particularly harmful to portfolio values, Mr. Hayes said.

He pointed to the recent experience of DeKalb County, Ga., the rating for which slid from AA+ to BBB.

The decline forced the county to pay an extra 80 basis points on its debt, which slashed the value of its outstanding lower-coupon bonds.

CREDIT QUALITY

Credit quality, not methodology, is what is driving the downgrades, said Anne Van Praagh, chief credit officer at Moody’s Investors Service Inc.

“We have not had significant ratings changes because of methodology; the downgrades we’ve seen have been due to deteriorating credit quality,” she said, noting that downgrades have outpaced upgrades for the last 12 quarters.

Moody’s said last week in two reports that the outlook for states remains negative for a fifth straight year and the outlook for local governments are negative for a fourth.

Federal aid cuts, high unemployment and low consumer confidence led to the continued negative outlooks.

“While most state and local governments have demonstrated a willingness to adjust their budgets to the realities of the downturn, they still face significant cost pressures that revenue growth alone will not solve,” said Toby Cook, author of the local-government outlook.

States will see the biggest strains from increasing Medicaid and pension costs but will benefit from low borrowing costs as revenue growth moderates, the Moody’s report said.

The agency’s median rating on states is Aa1, its second-highest level.

“Tentative economic growth could still be knocked off course by contagion caused by the European recession and debt crisis,” said Nicholas Samuels, author of the state report.

Representatives from Fitch Ratings Ltd. and Standard and Poor’s didn’t return calls seeking comment.

If creditworthiness declines across the board, muni bondholders are unlikely to see the total returns they enjoyed in 2011.

Muni bonds gained just over 10% last year, narrowly edging out U.S. Treasuries as the best-performing fixed-income asset class. That was surprising, as the year started out with analyst Meredith Whitney’s prediction of “hundreds of billions of dollars of defaults.”

Ramesh Gulati, principal at Gulati Asset Management LLC, said that he is reducing his clients’ muni bond exposure, especially on the local level, where he expects defaults to pick up.

“Munis are still going to be an asset class you have to have for high-net-worth clients, but we’re starting to be much more selective,” he said.

Mr. Gulati isn’t alone.

Through the first half of last year, investors couldn’t flee from muni bonds fast enough, draining about $42 billion from muni mutual funds at the peak of withdrawals. Although widespread defaults never came to pass, investors still have replaced only about half their withdrawals.

Meanwhile, states and municipalities were cutting spending and slowing their issuance of muni bonds.

The 32% drop in issuance, combined with withdrawal-driven lower prices and a flight to Treasuries, created a “perfect storm” of opportunity for muni bond investors, Mr. Hayes said.

“TAX-FREE INCOME’

“The attraction of municipal bonds has traditionally been their tax-free income,” he said, noting that munis long have offered about 85% of the yield of Treasuries, with the 15-percentage-point difference being considered a discount for the tax benefit.

But now, the yields on Treasuries are barely measurable and the spread between their yields and those of municipals has been upended.

“Now you see munis in the 120% to 200% of Treasury yield range,” Mr. Early said.

Given that shift, investors should return to a focus on income and concentrate less on potential return, Mr. Hayes said.

“In a world where demand for income is so strong, munis make more sense than ever,” he said.

Still, advisers should be careful that they aren’t just reaching for the highest yield.

High-yield muni bond funds, which returned 16% over the past year, according to Morningstar Inc., seem to have a “bit of a yield grab going on,” Mr. Hayes said.

High-yielding municipals also are the most susceptible to the dreaded superdowngrades, Mr. Early said.

This story was supplemented with reporting from Bloomberg News.

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