Top-rated municipal bonds could be looking even more attractive now that Moody’s Ratings has trimmed the United States’ pristine Aaa rating, according to Hilltop Securities. Moody’s was the last of the three major credit rating agencies to cut the U.S.’ sovereign credit rating, dialing it back one notch to Aa1 from Aaa on Friday. The ratings agency pointed to the ballooning burden of the federal government’s budget as one of the culprits behind the downgrade. “Successive U.S. administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs,” the agency noted. The downgrade of the U.S. puts a halo on municipalities with sterling Aaa ratings, however, according to Tom Kozlik, head of public policy and municipal strategy at Hilltop Securities. “Most investors in the muni bond market … are trying to preserve capital and want some return,” Kozlik said in a call with CNBC. “They don’t want to deal with headline risk. They don’t want to deal with questions about state or local government budgets.” “Those are some of the big reasons that muni investors will start to really focus on high quality,” he added. A focus on stable tax-free income Municipal bonds are beloved by high-net-worth investors. They provide interest income that’s free from federal taxes – and state and local taxes if the investor resides in the issuing state and city. The bonds are also generally backed by the full faith and credit of the issuer, which makes them less of a default risk than corporate bonds. The trade-off for this measure of safety, plus the added tax benefit, is that yields on munis are almlst always lower than corporates. An investor in the 32% tax bracket who is also facing the net investment income tax of 3.8% but who buys a tax-free muni bond yielding 3.0% would have to find a taxable corporate bond with a yield of 4.67% in order to get comparable results, New York Life Investments found . The reliability of this tax-free income is why investors are such big fans of muni bonds. Municipalities that manage to hold onto their top ratings by definition have the fiscal management and stable revenue streams to back it up. “In fact, in this post-downgrade environment, such high ratings can become even more valuable, signaling exceptional credit quality in a market where top ratings are increasingly scarce,” Kozlik said in a Monday report. “For investors, Aaa/AAA/AAA-rated municipal bonds may stand out even more as safe, high-quality options amid broader fiscal uncertainty,” he said. Investors snapping up individual issues will want to be picky as they scan the universe of available bonds. “I think from a credit quality standpoint, even though there are going to be challenges for certain credits – and there are more challenges, higher ed for instance – investors will need to be more selective,” Kozlik said. “Overall, the muni bond sector is still one where the credit quality is very strong.” From a bond fund perspective, investors don’t have to take too much of a leg down in quality in order to find attractive tax-advantaged yields. The 30-day SEC yield on the Vanguard Tax-Exempt Bond ETF (VTEB) is 3.94%, with an expense ratio of 0.03%. Roughly 18% of the fund’s holdings are in AAA-rated issues, while around 60% of its holdings are in AA-rated bonds. Watching for sector risk within munis While the direct impact of the U.S.’ downgrade on the muni market should be limited, federal funding is a key part of revenue for certain sectors, wrote Jon North, municipal bond analyst at Wells Fargo Investment Institute, in a note on Monday. He noted that federal grants to states, cities and counties are vulnerable in the event the U.S. tries closing its budget gaps by slashing spending. However, corners of the muni bond market that are tied to sales and hotels taxes, as well as land-secured bonds, have “minimal exposure to federal funding and therefore have the least direct impact from Moody’s action,” North added.
