Munis largely ignore Fitch downgrade, but wider economic impact unclear

Fitch Ratings’ downgrade of the United States’ long-term foreign currency issuer default rating to AA-plus from AAA should have little impact on the muni market, but may be of wider concern for the economy overall, market participants say.

While it’s still relatively early to tell how much munis will be impacted, Kara South, a municipal bond portfolio manager at GW&K Investment Management, said the market will use the S&P Global Ratings downgrade from 2011 as a roadmap. The rating agency downgraded the U.S. credit to AA-plus from AAA that year, followed by downgrades of municipal bonds.

Fitch said in a release the downgrade reflects “the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.”

In late May, Fitch warned it might downgrade the United States’ AAA credit amid a worsening showdown over the country’s debt limit, putting the nation’s issuer default rating on rating negative watch.

While Fitch would not confirm if certain securities would be downgraded as well, Arlene Bohner, head of Fitch’s U.S. public finance department, said that when the ratings agency placed the United States’ sovereign credit on ratings watch negative back in May, it also placed some securities on ratings watch negative as well.

At the time, Fitch said if the U.S. credit was downgraded, those securities would be downgraded as well.

Those securities currently on ratings watch negative are “pre-refunded bonds, whose repayments are wholly dependent on the triple-A-rated U.S. government and agency obligations that are held in escrow; some municipal housing that are primarily secured by mortgage-backed securities issued by Ginnie Mae, Fannie Mae and Freddie Mac; and debt issued by the Tennessee Valley Authority,” she said.

“Ratings that are on ratings watch [negative] have all been previously disclosed as having this dependence with the US sovereign, so it shouldn’t surprise anybody,” Bohner said.

However, she doesn’t believe the downgrade of the U.S. sovereign credit to a AA-plus level warrants the “reevaluation of most of the AAA ratings that we have on municipal bonds.”

State and local governments, along with the vast majority of U.S. public finance issuers enjoy a “robust level of fiscal independence from the federal government,” Bohner noted.

So Fitch’s ratings don’t “assume that there will be a government backstop of public finance issuers’ financial obligations and they also not include preclude rating above AA-plus,” she said. 

The U.S. remains the “safe haven during times of market stress and the downgrade will likely not change that,” said Lawrence Gillum, chief fixed income strategist for LPL Financial.

That was further shown by the non-reaction from the bond market following the announcement, not to mention this is not the first time the U.S. has been downgraded, he said.

Treasuries reacted Wednesday more to the ADP Employment Report that surprised to the upside and municipals were focused on the larger primary market and August redemption bid lists circulating. Equities, however, were in the red.

While the Fitch downgrade of the country’s debt credit rating may not immediately impact the muni market, it “is having a sour effect on investor sentiment, as it raises tough questions about the foreseeable future,” said José Torres, Senior Economist at Interactive Brokers.

While lowering the rating to AA+, Fitch “cited the ‘erosion of governance’ and the country’s growing cost of debt service, with debt expected to grow to 118% of GDP by 2025.”

In the immediate term, he said “the downgrade is likely to impact markets and interest rates at the margin, but if other rating agencies follow suit, Treasury yields could rise much more significantly, which would increase borrowing costs for the U.S. and corporations.”

Higher bond yields, Torres said, “would also make debt securities more attractive relative to equities, creating a headwind for the stock market.”

There would be a similar effect for munis as a result.

While the surprise Fitch downgrade may “elicit heavy response and criticism,” Jeff Lipton, managing director of credit research at Oppenheimer, does not foresee a “substantive impact upon municipal credit or municipal market efficiency at this time.”

He does question the timing of the rating downgrade, noting “there is no looming crisis, the U.S. economy has emerged from the COVID-driven shutdown with strength and resiliency, and quite frankly, debt ceilings and the threat of a government shutdown have been consistent participants among fiscal and budgetary deliberations for a very long time.”

Muni market participants noted the juxtaposition of the federal government’s finances versus state governments.

“The event serves as a useful reminder of the inherent creditworthiness of U.S. states which are required to have balanced budgets,” said James Pruskowski, chief investment officer at 16Rock Asset Manager. “U.S. federal debt and deficit resolution may very well mean an eventual rise in tax rates, both at the individual and corporate level, which should bode well for the municipal asset class.”

Due to the market being in a different landscape than 2011, which was still dealing with the effects of the financial crisis and Great Recession, Tom Kozlik, managing director and head of public policy and municipal strategy at Hilltop Securities, does not expect credit shocks like those seen then.

Overall, “a resilient U.S. economy and healthy pandemic-related stimulus have helped the market’s broader credit conditions to remain healthy,” said Matthew Gastall, head of Wealth Management Municipal Research at Morgan Stanley. However, he noted fundamentals vary on a credit-by-credit basis.

In regard to the Fitch downgrade, he said the market’s summer technicals are constructive and, for muni credit, states and local governments are broadly in a strong starting position.

However, there may be other knock-on effects, sources said.

Ratings agencies have generally held that no subdivision may be rated higher than the sovereign, though there are some exceptions, said John Hallacy, president at John Hallacy Consulting.

If all three ratings agencies move the rating to AA-plus (or Moody’s equivalent Aa1), then the ratings agencies and others may reassess the municipal AAAs in the market, he noted.

Moody’s Investors Service affirmed its AAA rating of the U.S. sovereign credit profile in mid-July. At the time, Moody’s said in a report the rating the credit strengths “counterbalance the sovereign’s lower fiscal strength, which we expect to weaken further along with federal debt affordability.”

Moody’s noted rating and outlook could be downgraded if the rating agencies were concluded “policymakers were unlikely to respond effectively in the coming years to the country’s growing fiscal challenges through measures to increase government revenue or reform entitlement spending.”

Since S&P’s downgrade in 2011, which Hallacy said was right to warn about debt levels, he said the U.S. debt levels have grown greatly and seem set to continue to grow.

“It’s much to our consternation that Congress can’t do the budget process smoothly,” he said.

“We have an aging population, with a growing portion using Social Security and Medicare,” with expects saying Social Security and Medicare trust funds will run out of money in the 2030s unless action is taken, he noted.

At some point, Hallacy noted action will have to be taken to address these funds.

Market participants, though, remain split was on impacts on the downgrade to the economy as a whole.

University of Central Florida economist Sean Snaith described the downgrade as “troubling.”

“This is a warning shot across the U.S. government’s bow that it needs to right its fiscal ship,” he said. “You can’t just spend trillions of dollars more than you have in revenue every year and expect no ill consequences.”

Quincy Krosby, chief global strategist for LPL Financial, concurred, saying Fitch’s message was “stark.”

Moreover, he noted “it’s a message that played out in the debt ceiling drama, as both sides of the aisle acknowledged that the deficit has to be quelled, yet little was accomplished.” 

Ultimately, Krosby said if the deficit isn’t contained, “taxes will be raised to the point that the engine of the U.S. economy, the all-important consumer, will have considerably less discretionary income.”

Due to “the ability to attract funding for the country’s deficit through Treasury market auctions,” yields, especially the 10-year UST, will have to climb higher, he noted.

“This would provide direct — and practical — competition to the equity market,” he said.

Unless inflationary pressures cause the 10-year UST to move higher, which can be “extinguished by further interest rate hikes,” Krosby noted the message from Fitch shouldn’t be ignored.  

However, Padhraic Garvey, ING’s regional head of research, argued the Fitch downgrade “in itself is not a huge deal.”

“Market participants will continue to view the Treasury curve as the global risk-free curve, containing the spectrum of risk-free rates,” he said. “However, what the Fitch move does do is focus minds on U.S. debt dynamics.”

The “congressional budgetary office has the U.S. debt GDP ratio approaching 200% of GDP by 2050 on current policies,” and that’s not a sustainable path, Garvey said.

A higher-than-expected issuance projection from the Treasury for the upcoming quarter serves as a “further reminder of the supply pressure for Treasuries,” he said.

For the first time in a long time, issuance pressure is “being factored in as a valuation factor for Treasuries, adding to the upside pressure that we had already identified based off the paring back of the market’s Fed rate cut expectations,” he said.

Guy LaBas, chief fixed income strategist at Janney Montgomery Scott, said the large federal debt is of “very mild concern over the next 10 to 20 years.”

LeBas said economic growth will help as there’s been substantial nominal growth in the last two years, and he expects nominal growth in the range of 5% per year in the 2020s. Over time, he said, federal debt/GDP ratio should go down.

Kozlik warned that reducing debt, if lawmakers would decide to act, may have implications for the muni market.

“The debt to GDP ratio must be brought down and one of the ways lawmakers could do that would be to eliminate tax expenditures generally and to target the municipal tax-exemption specifically,” Kozlik said.

President Joe Biden and Congress will probably not target the tax-exemption in the federal budget to be approved in the fall, he said.

However, Kozlik noted there may be talk about it as part of a tax reform or deficit reduction package in the next three years.