Muni Bonds May Face Downgrades on Final U.S. Cuts, S&P Says

Standard & Poor’s, the credit rating company that cut the U.S. to AA+, said spending cuts following President Barack Obama’s deal with Congress to raise the federal debt limit may lead to downgrades of municipal credits.

The company, which said earlier this month that states and local governments could remain AAA even after the U.S. cut, said in a report today downgrades may follow a bipartisan panel’s recommendations to reduce federal funding in November. Ratings changes would come based on “differing levels of reliance on federal funding, and varying management capabilities,” and, after the Budget Control Act of 2011, will be felt “unevenly across the sector,” S&P said.

“Experience tells me I would expect there to be some downgrades,” Gabriel Petek, an S&P analyst, said in a telephone interview. “These cuts are coming in addition to the losses of revenue that already came during the recession.”

The initial budget cuts would be smaller than the revenue losses during the recession that ended in June 2009, he said. States lost $67 billion in aggregate during the 18-month contraction, the report said. The federal government has planned $7 billion in cuts, most of which won’t be implemented until 2013, giving states some time to prepare, Petek said.

S&P will begin evaluating states and local governments Nov. 23, when a panel of 12 members of Congress, split evenly between Republicans and Democrats, is supposed to come up with proposals, Petek said. The committee is charged with finding $1.5 trillion of spending cuts over 10 years under a debt-reduction deal Obama reached with Congress on Aug. 2.

Federal Funding

In 2009, when the U.S. introduced economic stimulus, federal spending on average was 24.6 percent of state gross domestic product, the report said. States that had federal funds representing more than 30 percent of GDP included Alabama, Alaska, Hawaii, Kentucky, Maryland, Montana, Mississippi, New Mexico and West Virginia. The state with the lowest percentage was Delaware.

“We do not have immediate concerns at the state and local levels,” said Natalie Cohen, managing director and senior municipal-bond analyst for Wells Fargo Securities, in an Aug. 16 report.

The 11,500 municipal bonds already downgraded from AAA in lockstep with the U.S. were a “logical extension,” and “not a symptom of a meltdown in the municipal-bond market,” she wrote. The debt was directly dependent on federal funding.

S&P mentioned possible changes to the municipal market if tax policy is altered. If tax cuts enacted during George W. Bush’s presidency are allowed to expire, federal taxes would increase and the tax exemption on municipal bonds would be more attractive to investors and drive yields on municipal bonds lower, S&P said.

Alternatively, Congress could limit some of the tax exemptions on municipal bonds to raise more government revenue, which would likely increase interest costs, S&P said.