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By Jeremy Glaser | 08-08-2011 06:07 PM

Austerity a Headwind for Munis

BlackRock's Peter Hayes thinks the age of belt-tightening could squeeze municipalities' abilities to pay back bondholders, but he doesn't expect a huge increase in defaults.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm pleased to be joined today by Peter Hayes. He is the head of BlackRock's municipal bond investment team. We're going to take a look at what some of the events of past days could mean for municipal bond investors.

Peter, thanks so much for joining me today.

Peter Hayes: You're welcome, Jeremy. Nice to be here. Thanks.

Glaser: So, I think, something that's on a lot of people's minds is after the sovereign downgrade by S&P of the United States sovereign debt. What's that going to mean for the rating of municipal bonds? Do you expect a lot of downgrades of municipal bond issuances in the coming weeks?

Hayes: Clearly, the municipal market is going to be one of the asset classes that, I think, will be more affected, not so much by the downgrade, but by the deficit-reduction package and by fiscal austerity and some of the spending cuts that will take place during the next several years.

So, let's think about the municipal market in general. It's a $3 trillion market. The part of the market that gets directly affected by the sovereign rating of the U.S. would be a small part of the market, about probably 8%-9% of the market. It might even be less because S&P doesn't rate every single issue within that 9%. That part of the market is referred to as a prerefunded market--the escrowed market and also some housing bonds that are backed by the agencies.

In the case of pre-refunded and escrow securities, the issuer eventually funds his debt, places the proceeds, and buys Treasury securities, enough to payoff principal interest. So, the backing are actually government securities.

So, that would be immediate, and that would be affected by the rating agencies, something we expect to see over the next several days. But again it's small part of the market, and it's also not going to affect the ability to repay that debt. Most of those securities are short-term in nature. But you will see downgrades pretty immediately there as a direct correlation to what happened with S&P's downgrading of debt.

The broader part of the market is the less-certain part of the market, and that's affected not by really the downgrade, but by the fiscal austerity measures and the spending cuts. In other words, how reliant are states on things like Medicaid? How reliant are highways on some of the municipal issuers that issue for the purpose of highway bonds? How affected will they be by cuts in federal highway transportation funds? How will hospitals be affected by cuts in Medicaid? How will local governments be affected also by the cutbacks in the states? This includes things like federal procurements, and public funding in the public education sector.

So, there's a lot of uncertainty there. We think that there will be some downgrades. There will mostly be one-notch downgrades. Its not going to dramatically change the value as they exist in the marketplace, nor is it going to affect their ability to repay their debt.

So, to answer your question, we don't think there's going to be widespread default, much as we've said all along. Again, we do think there will be downgrades, but it's also going to be a timing mechanism. How long will it take the agencies to get through the deficit package to understand the flow of funds and the implications of different states, local governments, regions, and different sectors in the market? That's going to take some time, but there will be downgrades that will occur.

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