Fixed income Muni implications of Fitch surprise downgrade

• On 1 August 2023, Fitch Ratings surprised the financial markets by downgrading its long-term foreign currency issuer rating of the United States to AA+ from AAA. The rating agency cited a “deterioration in the standards of governance” and “repeated debt-limit political standoffs and last-minute resolutions” to recurring debt ceiling stalemates as contributing factors in its decision to reduce its assessment of the credit quality of US government securities.
• Following this rating revision, Fitch also downgraded certain municipal bonds that are linked to the US government debt rating due to their reliance on the sovereign credit for repayment. The related downgrades include USD 21.5bn of power bonds issued by the Tennessee Valley Authority, USD 3.5bn of pre-refunded municipal bonds, and USD 1.8bn of municipal housing bonds, as reported by Bloomberg. We do not expect the Fitch downgrade of the muni linked credits to have a material impact on spreads. Despite the rating action, we view AA+ rated municipal bonds as high credit quality fixed income investments.
• Last week, munis sold off taking their cues from weakness witnessed in the US Treasury market. Yields on high grade munis increased by 17bps to 22bps across the curve. Despite the sell-off, tax-exempt munis (+2%) have outperformed taxable government related debt (+0.6%) on a year-to-date basis.
• In the new issue market, the largest deal expected to price this week is ~USD 1.015bn New York City general obligation bonds. Overall, net supply remains negative this month, representing a tailwind for the market.
• Short-dated tax-exempt municipal bonds have cheapened relative to their taxable fixed income counterparts. As a point of reference, the 2-year AAA muni-to-Treasury yield ratio now sits at 65%, up from only 60% in mid-July. That said, muni investors can obtain better relative values further out on the curve (12-year spot and beyond).

Buy high-quality munis
We continue to favor positioning muni assets in high-quality sectors rather than lower-rated high yield munis in the face of macroeconomic uncertainty. Municipal electric utilities, state governments, and essential service water and sewer debt are all good examples of muni sectors that we believe should exhibit credit quality resilience in an economic slowdown. By contrast, not-for-profit hospital bonds and pockets of the private higher-education sector face more challenges from a credit standpoint. That said, our credit team has identified select opportunities from larger obligors with strong credit metrics within the higher risk hospital sector.

Add some duration
Rather than waiting for the Fed to confirm an end to the rate hiking cycle, we believe that investors should allocate some space to durable tax-exempt income to portfolios through longer-duration, high-quality municipal bonds. Yields on longer-dated 20-year high grade AA munis now sit at about 3.8%. By comparison, these yields are roughly 35 basis points higher than the average over the past 20 years, and 250bps higher than the all-time historical low (1.3%) witnessed in 2021 July.

Main contributor: Kathleen McNamara

Read the original Blog: Muni bond bullets 8 August 2023

Select US fixed income municipal research
Municipal Market Guide: Built by bonds, 27 July 2023
Blog: Muni bond bullets, 10 July 2023
Blog: Muni 1H23 performance update, 5 July 2023
Infrastructure: Made in America, 27 June 2023
Spotlight on long-term trends: Themes for yield, 31 May 2023
Education Note: Understanding bonds: Debating individual bonds versus bond funds, 29 March 2023
Education Note: Tax implications on discount munis, 17 February 2023