While the impact on Treasurys as a result of the downgrade may be limited (after all the other side of the Atlantic is about as ugly as the US, so where could $8 trillion in marketable USTs practically go... at least for now), the same may not be said about the far smaller, $2.9 trillion municipal market, which is about to see a blanket downgrade tomorrow as S&P warned on Friday night, and of which Matt Fabian of Municipal Market Advisors earlier said that "There will be hundreds and hundreds of municipal downgrades, which will not do well to bolster investor confidence." The scary bit: "Treasuries may be able to shake off a real impact from the downgrade. Munis I’m less sure about." Indeed, with futures already trading, and most risk assets experiencing a brief knee jerk reaction on a global coordinated PPT response by the G-7, there is still little clear understanding of what will really happen to not only the traditional system but to shadow liabilities such as repos and money markets. And munis are just one part of all of this. So what will happen if tomorrow the muni market starts unravellling, as Whitney, among so many others, has predicted? For that we turn to JP Morgan's Peter DeGroot for some quick observations.
From JP Morgan on munis:
- Market volatility should continue next week with S&P’s US downgrade following this week’s manic capital market performance
- Tax-exempt yield movements will likely remain unstable, as dictated by benchmark Treasury yields, despite low long-term new issue volume next week
- Instability in the US credit may further net outflows in the municipal space. Net issuance, however, remains supportive of liquidity
- After S&P’s announcement of the US downgrade, expect follow-through on municipals directly supported by the US credit, as well as those highly reliant on the federal government
- The Central Falls bankruptcy case will be important to follow because of its potential broad implications for local government credit
- While we have been warning for some time of the elevated strain on local government fiscal positions, Central Falls could potentially have ramifications that could support local credit quality by (i) bringing clarity to the priority of the GO credit, (ii) providing a model for state activism, and (iii) adding steam to the momentum of some small cities using Chapter 9 to reduce fixed labor costs
What follows for munis as a result of the US rating action:
We anticipate some period of volatile/higher Treasury yields over the short horizon. We do not expect materially higher US borrowing costs as a result of the downgrade given that we do not expect sizable forced selling of Treasury bonds; rate movement of other sovereigns has been muted when faced with similar ratings actions; Treasuries quickly retraced their yield movements following the initial warning by the rating agencies; and the spot metrics for the US are arguably within the range for a AAA sovereign rating (see Treasuries).
We can expect S&P will downgrade all municipals backed by the US credit such as pre-refunded bonds and agency-backed municipal debt. Further, those credits with large fiscal transfer dependencies would also likely see in-kind downgrades. The rating implications are likely similar to those specified by Moody’s in their 7/13/2011 note.
Moody’s suggested moving approximately 7,000 muni bond ratings totaling $130bn, “directly linked” credits in lock-step with the US credit. Moody’s also reviewed “indirectly related” credits and placed five of the fifteen states they rate as Aaa on review for potential downgrade. These would also move in lock-step with the federal government rating.
Issuance limps along in August
The tax-exempt bond market will again take cues from the broader US fixed income markets, based on news of the US downgrade. Yield movements will likely remain unstable, despite low long-term new issue volume. Next week we expect supply of just $3bn based on late adds to the calendar.
Issuance in this range would be the lowest in four months (excluding the holidayshorted week of 7/5/11; Exhibit 3). This follows $4.9bn in primary market supply this week. The largest deal currently on next week’s docket is a $300mn Los Angeles Department of Water remarketing followed by $268mn Florida State Board of Education bonds. The expected light calendar should tick higher as refundings rush to take advantage of fight to quality yield levels if they hold after the S&P downgrade news.
The lack of a primary calendar and investor need for yield against the backdrop of low and dropping highgrade yields provide a fertile environment for paring typically hard to trade structures and credits. Investors may be motivated to lock in gains on these names and structures while demand is robust to preserve total return performance in the event of an unexpected shift in liquidity between now and year-end.
Municipal fund net outflows resurge on global risk-off trade
Broader credit market uncertainty may prolong muni outflows in the near term.
For the period ending 8/3/2011, combined weekly and monthly municipal reporters registered the highest net outflows (-$232mn) since the first week of June. Highyield funds (-$117mn) and long-term funds (-$726mn) also experienced net outflows. Intermediate funds (+$314mn) enjoyed positive flows for the ninth consecutive week.
Municipal funds who report weekly were also negative (-$861mn) for the period ending 8/3/2011. High-yield funds (-$118mn), long-term funds (-$732mn) and intermediate funds (-$55mn) all experienced net outflows (Exhibit 4).
And a quick primer on Chapter 9 bankruptcy protection from DeGroot as pertains to not only last week's Central Falls bankruptcy filing, but to what me be "hundreds and hundreds" just over the horizon.
And after all that, the conclusion is that there is no conlusion, and only time will tell what will ultimately happen. That said, anyone actually predicting that a historic US downgrade will have no impact, is an idiot.