Moody’s Defied as Local Bond Risk Falls to 2010 Low: Muni Credit

Investor confidence in U.S. municipal debt is the highest in three years even as Moody’s Investors Service warns that local-government credit quality is set to weaken for the 18th straight quarter.

It cost the annual equivalent of as little as $133,000 this month to protect $10 million of local bonds for 10 years through credit-default swaps, according to Markit Group Ltd. data compiled by Bloomberg. That’s the cheapest since April 2010. The municipal market isn’t alone in benefiting from bets on economic growth. The cost of contracts linked to U.S. corporate debt is close to the lowest since 2007, and for Western European sovereign obligations it’s the cheapest since 2010.

For munis, the declining price shows investors in the $3.7 trillion market view a record $311 billion of Moody’s public-finance downgrades last year as failing to capture the improving fiscal health of states and cities. The fewest issuers since 2009 have defaulted this year as states are seeing tax collections exceed prerecession peaks.

Rating downgrades “don’t overshadow the fact that there’s a bullish outlook on state and local credits,” said Vikram Rai, a fixed-income strategist at Citigroup Inc. in New York. “There’s an improving economy, an improving housing market and higher state tax revenues.”

Market Reflection

While non-traditional muni investors such as hedge funds are among the biggest users of the swaps, the contracts reflect improving sentiment across the broader market as the economy recovers from the recession that ended in 2009. Tax revenue in the 50 states this year will surpass the record of $670 billion from 2008, according to Todd Haggerty, who tracks budget issues for the Denver-based National Conference of State Legislatures.

The swaps also reflect declining interest rates on local debt as investors gain confidence in municipalities’ fiscal prospects and as the Federal Reserve holds its target overnight interest rate near zero. Yields remain close to a generational low as individuals have added about $4.7 billion to muni mutual funds this year, Lipper US Fund Flows data show.

Twenty municipal issuers have defaulted in 2013 as of May 8, according to Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors. That’s the fewest since at least 2009, when he began tracking failures to pay.

Protection Payment

The swaps are contracts in which an investor or bank pays a fee for protection against a missed debt payment. The Markit MCDX index consists of 50 contracts of muni issuers, excluding tobacco and health-care. In the case of California, the expense of covering the state’s debt fell this month to the lowest since 2008.

“If the cost of protection is falling, it probably means hedge funds perceive a lower chance of negative headlines,” Fabian said. “Credit quality is at worst stabilizing, and perhaps even improving.”

The swap prices jumped 14 percent in the three weeks after banking analyst Meredith Whitney forecast “hundreds of billions of dollars” of defaults in 2011. The remarks in a December 2010 appearance on CBS Corp.’s “60 Minutes” helped push investors to withdraw the most money in two decades from muni funds.

Though widespread failures never occurred, the number of defaults from U.S. municipal issuers rated by Moody’s has more than tripled to an annual average of 4.6 since 2007, the company said in a report this month. That’s about three times the rate from 1970 to 2007.

Default Dimension

Moody’s “wouldn’t be surprised to see five to 10 defaults” of issuers it rates in 2013, Anne Van Praagh, an analyst at the New York-based company, said in an interview. Speculative-grade municipalities may also increase, she said.

The company had 157 so-called superdowngrades of three or more levels in 2012, the most since at least 2007.

About 87 percent of Moody’s rating changes in the first quarter of 2013 were downgrades, the company said in an April 29 report. It marked the 17th straight quarter that rating cuts exceeded upgrades.

“While the economy is recovering, the growth is really sluggish, and it’s not robust enough to lift muni issuers as a whole out of the slump they’ve been in for several years,” said Naomi Richman, a Moody’s analyst, in a telephone interview.

Economy Ripple

Citigroup’s Rai disagreed about the impact of a growing economy.

The U.S. budget deficit will drop to $378 billion in 2015 from a record $1.4 trillion in 2009, according to Congressional Budget Office data. The federal government will post a $642 billion deficit this year, the first time in five years that the shortfall has been less than $1 trillion.

Sales of previously owned U.S. homes rose in April to the highest level in more than three years, while the nation’s unemployment rate is the lowest since December 2008. U.S. gross domestic product will grow 2.7 percent in 2014, accelerating from a 2 percent clip this year, according to the median forecast of analysts surveyed by Bloomberg News.

“Try making up that amount with budget cuts -- it’s almost impossible to do that,” Rai said. “Whenever macro factors improve, it has a very large waterfall effect on our credits.”

Localities led by New York City are issuing $6.7 billion in debt this week, Bloomberg data show. That’s set to plunge to $1.1 billion next week, the least since January, as U.S. financial markets shut May 27 for the Memorial Day holiday. The slowdown comes after investors added the most money to muni mutual funds since February.

At 1.87 percent, yields on benchmark 10-year munis compare with 2.04 percent for similar-maturity Treasuries.

The ratio of the two interest rates, a gauge of relative value, is about 92 percent. It has been below 100 percent for 10 straight sessions, the longest streak since February. The lower the figure, the more expensive munis are compared with federal securities.

Before it's here, it's on the Bloomberg Terminal.