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Austerity a Headwind for Munis

Jeremy Glaser

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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Glaser: So, when these downgrades do occur would you expect it to be a big dislocation in terms of pricing or in terms of investors are holding these bonds? Or do you think that the market will take it in stride, somewhat as the Treasury market has with the U.S. downgrade?

Hayes: It should take it in stride. Again, the part of the market that gets immediately affected is the prefunded market that's based on what you think your outlook would be for repayment by the U.S. government for their obligations, and we think that it will continue to pay. I think that's what the market believes now, especially based on the price action Monday.

So, there shouldn't be much of an impact there. I think the lingering effect will be around the uncertainty among downgrades of states and local governments and other revenue sectors as well. But that could create some uncertainty, and that uncertainty may lead to either a drop off in demand or it could even lead to perhaps selling or mutual fund outflows.

We don't think it's going to be widespread, because again we think that the downgrades are going to be at most one notch. They're not going to have a great impact on the value of that bond. But nonetheless, if you do see a persistent time period of mutual fund outflows, that could have a negative impact on the market. But we don't think it's necessarily going to be very volatile, very widespread, or result in widespread dislocation in the market.

Glaser: So, looking a little bit closer to that supply/demand dynamic, you mentioned that there is potential downsize to demand. What about the supply side? After the expiration of the Build America Bond program, issuance seems to have dropped off quite a bit. Do you expect that issuance to remain low and for there to be limited new supply into the market, or do you think that municipalities will come back and try to raise some money in the future?

Hayes: That's a good question. When we came out of 2010 into 2011, that was a big question mark overhanging the market because with the Build America Bonds gone, as you mentioned, all that supply theoretically should have come back to the tax-exempt market. It actually hasn't. The lack of supply, at least in the first seven months of this year, has been a big driver of positive price performance, one of the reasons why municipals were the best-performing fixed-income asset class in the second quarter of this year and a big driver of price performance overall this year.

So, what happens with supply going forward will also dictate, to some degree, how the market performs.

What we think was happening is a couple of things. One is that some of this uncertainty that I talked about earlier with regard to ratings downgrades might in fact keep issuers on the sidelines. We don't see much of a calendar this week. In fact, even during the next 30 days, we don't see much of the calendar materializing.

So, we think that this fiscal austerity is also taking over in terms of how issuers look at their debt. There's a real aversion, a real unwillingness to take on additional debt in this particular environment of fiscal austerity, and we think ultimately that some of the uncertainty that I talked about with downgrades probably keeps supply low for the remainder of this year.

Glaser: So, certainly it sounds like austerity would be the big driver of the municipal market for the rest of the year, not so much the actual rating downgrades?

Hayes: Right.

Glaser: Peter, thank you so much for taking the time today. We really appreciate it.

Hayes: You're very welcome, Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser.