The Moody’s downgrade of the US rating to Aa1 from Aaa had a ripple effect through the bond markets, in the form of downgraded credits that depend on government support, assume a certain level of government support, or are supported by other federal government securities that also lost the Aaa rating. In some respects, the downgrade was a nonevent, because the US had already lost its S&P (2011) and Fitch (2013) AAA ratings years ago. The Moody’s rating change, which was primarily based on the failure of consecutive administrations and Congresses to rein in the deficit, came at a time when there are expectations that the federal deficit and the interest expense to service the debt are not going to be reduced any time soon. For a discussion of the market reaction to the downgrades since 2001, see John Mousseau’s commentary “US Downgrade Then and Now.”
The outlook on the US was changed to stable from negative. Moody’s emphasized in their opinion the resilient nature of the United States, with its exceptional economic strength, high-quality institutions, and governance strength, as well as its extraordinary funding capacity, supported by the unique and central roles of the US dollar and Treasury bond market in the global financial system.
Affected Ratings Sampling
- Some global systemically important banks, or G-SIBs, had their deposit and unsecured debt ratings changed because of Moody’s action on the US. We will not list all of the actions but, for example, the long-term deposit ratings for the rated bank subsidiaries and branches of Bank of America Corporation (BAC), JPMorgan Chase & Co. (JPM), and Wells Fargo & Company (WFC) were downgraded to Aa2 from Aa1. Moody’s also downgraded to Aa2 from Aa1 the long-term senior unsecured debt ratings and issuer ratings for certain rated subsidiaries and branches of BAC and The Bank of New York Mellon Corporation (BNY). The downgraded G-SIBs previously incorporated one notch of US government support uplift, and this notch of support has now been removed from their ratings construct. Lower-rated G-SIBs, such as Citi and Goldman Sachs, were not affected.
Moody’s also announced that the US government downgrade had no impact on the score for the macro profile of the US banking system, which remains Strong+.
- Federal government-sponsored agencies (GSAs) such as Fannie Mae and the Federal Home Loan Banks saw downgraded ratings.
- Government institutions that issue muni bonds, such as the Smithsonian, also were downgraded, based on the high level of federal funding.
- Housing Finance Agency programs with federal guarantees or agency securities and high debt-to-asset ratios also lost their Aaa Moody’s ratings. HFA debt supported by other loans and reserves were not affected.
- Escrowed to maturity bonds, also known as pre-refunded bonds, which are secured by government securities matching the maturity schedule, also lost the Moody’s Aaa rating.
- The before mentioned downgraded banks’ letter of credit-backed bonds were downgraded. Municipal variable rate demand bonds often have a bank letter of credit backing the bonds.
- Bonds that are secured by federal leases were also downgraded.
Ratings Not Affected – Muni Bonds
State and local governments that are rated Aaa were not affected by Moody’s lowered federal government rating, because states are sovereign entities and independently manage their own affairs, including establishing taxation systems and determining fund allocation. Local governments also have autonomy to operate under state administration. In many other countries, the country rating becomes a ceiling on local government ratings.
Other efforts that the federal government is embarking on, such as reduced direct aid to states for Medicaid, education, and FEMA, may affect state and local government ratings by all rating agencies. Future ratings will depend on the final form of the federal changes and how revenues are shared. This shift comes at a time when, after years of underinvestment, munis are issuing bonds for infrastructure investment and choosing to keep reserves on hand instead of applying them to capital projects, in order to ensure that they have sufficient funds to be flexible in the face of potential economic stress and changing federal funding. Supply this year is estimated to reach $475–525 billion, up from an average of $400+ billion for the past few years, and over $500 billion in 2024. Munis generally have good management and strong budgeting practices, better pension funding, and accumulated reserves that help provide resiliency.
At Cumberland Advisors we invest in high quality bonds in our fixed income strategies. The tax-exempt strategies invest in high-credit-quality munis and the taxable strategies invest in corporates – including banks - taxable munis and treasuries. All portfolio strategies have an average rating in the AA category.
Patricia Healy, CFA
SVP, Research
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