The prevailing August municipal bond market story was the threat posed by the U.S. rating downgrade. The improving state tax situation and the search for better yields also led municipal bond market news in the past month.
Wholesale municipal rating downgrades unlikely
As we wrote in our market update The Effect of a U.S. Rating Downgrade, the downgrade did not surprise us. Internally, we have discussed a possible downgrade of the U.S. and its impact on other rated municipal issuers for some time. The downgrade of the U.S. was unprecedented and as such it is impossible to predict any outcome. However, in the near term, we do not believe there will be wholesale rating downgrades of municipal issuers excepting those issues either directly secured by U.S. Treasury issues (pre-refunded and escrowed to maturity issues) or indirectly secured by government agencies (such as certain housing and student loan issues).
This latest development leads to a glaring question. How do market participants interpret credit ratings? Therein lies the bottom line we have believed for a long time – at the outer edges, municipal bond credit analysis is as much an art as it is a science. Independent municipal bond credit research matters now more than ever.
State revenues improve for sixth quarter, fastest growth in six years
State revenue collection continued to improve in the second quarter of 2011 and boosted balance sheets. The Rockefeller Institute’s report on preliminary data from 46 early reporting states shows collections from major sources up 11.4 percent in the second quarter vs. the same quarter last year – the strongest year-over-year growth since the second quarter of 2005. Tax collections have now been growing for six consecutive quarters, reversing the trend set by five quarters of declines. Revenues were still 7.8 percent lower than in the same period three years ago.
The strong, continued tax collection growth in 2011 for every state except New Hampshire indicates that the revenue situation is slowly recovering for most state governments. Alaska, North Dakota, Illinois, Nebraska and New York showed the greatest total tax growth – with Illinois up 37.7 percent overall. Most states have closed their books for fiscal year 2011 and preliminary data show 8.4 percent tax revenue growth for the nation as a whole.
Municipal bond fund outflows signal search for better yields
A new round of outflows from municipal bond funds continued through every week of August. Unlike the municipal bond fund selloff of late 2010 driven largely by credit concerns, this new trend appears to be motivated by investors in search of better yields. As we mentioned in our Mid-Year Municipal Credit Update and other publications, municipal market yields are transitioning toward specific idiosyncratic issuer credit risk and away from the very homogenous “AAA-insured” interest rate sensitive environment.
While this may unnerve some municipal investors, it is a development that ultimately will reward those that have carefully followed our three pillars of municipal credit research. Investors willing to accept incrementally more credit risk will be compensated with a boost in yield. Additionally, investors in longer maturities will be rewarded for accepting the interest rate risk.
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
September 7, 2011
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