Alert August 11, 2011

S&P Downgrades U.S. Credit – Muni Bonds Hang Tough

On Friday, August 5, Standard & Poor’s Ratings Services (“S&P”) announced that, for the first time in history, it had lowered the rating of the United States’ sovereign debt. S&P announced the downgrade, from AAA to AA+, shortly after President Obama signed a bill raising the country’s borrowing limit and reducing federal spending – the culmination of a months-long Congressional battle between the two major political parties.  According to the S&P release, “[t]he political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed.”

Moody’s Investors Service, Inc. (“Moody’s”) and Fitch Ratings (“Fitch”) subsequently reaffirmed their respective triple-A ratings on U.S. debt, although both agencies warned that downgrades were possible if Congress does not enact future debt reduction measures.

Markets Respond

On the first day of trading after S&P’s announcement, the Dow Jones Industrial Average fell 634 points – the steepest single day decline since 2008. Stocks rebounded on Tuesday, with a 430-point gain, sparking investors’ hope that emotional selling, not economic defect, caused Monday’s decline. Wednesday saw the market plunge once again, however, by 520 points.

Although the stock market fluctuations certainly unnerved investors, most economists are more concerned about the impact the downgrade will have on the bond market. Many pundits initially feared that bond yields would rise to offset the increased credit risk.  If bond yields were to increase by 25 to 50 basis points, the federal government’s borrowing costs could jump as much as 20%.  Such increased costs would inevitably pass to state and local governments, businesses, and private individuals, potentially contributing to a double-dip recession.

In the days that have elapsed since S&P’s announcement, however, the bond market has responded positively.  Yesterday, the yield on 10-year U.S. Treasury notes dipped to an historic low of 2.17%, significantly lowering the federal government’s cost of borrowing.  30-Year Treasuries remained stable at 3.58%, just below 30-year municipal bonds, which also remained strong.

Municipal Bonds Going Forward

As of yesterday, S&P had lowered its ratings on more than 11,000 state and local bond issues, including pre-refunded bonds that were defeased by Treasuries, housing bonds secured by federal guarantees, and bonds backed by federal leases.  As a result, bond yields have weakened slightly, rising between 1 and 3 basis points on the longer maturities.