Municipal bonds were one of the darlings of 2011, but the threat of “super downgrades” or downgrades of two or more notches could have a big impact on prices.
Peter Hayes, head of municipals at BlackRock Inc., told advisers at the 2012 Investment Management Consultants Association in New York that he expects super downgrades to accelerate throughout the year.
“We're expecting a radical change in the methodology of the ratings agencies because of Dodd-Frank,” he said. One of the aspects of the Dodd-Frank Act requires ratings agencies to review their methodology for credit ratings annually, Mr. Hayes said.
The spreads between higher-rated municipal bonds and less-than-investment-grade ones are “dramatic,” so a severe downgrade could have a big impact on pricing, Mr. Hayes said.
Investors in municipal bonds also will have to consider the effect of likely tax policy changes, which should become clearer in the second half of the year. The ultimate outcome, though, will be decided by the outcomes of the presidential and congressional elections, Mr. Hayes said.
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Mr. Hayes still sees ample opportunity in the short term for municipal bonds.
Outflows for municipal bond funds peaked at $46 billion in 2010 and investors have only put about half that back into the market. An additional $10 to $15 billion of inflows are expected over the next three months, which should help drive demand.
Interest in munis also is on the rise because of new investors' entering the space. Typically, municipal bonds have been prized for their tax-free income. But since 2008, tax-exempt debt has been seen as having a better risk/reward premium than Treasury bonds, prompting a new wave of investors who aren't concerned about the tax benefits at all, Mr. Hayes said. As a result, “the tax benefit of the market has been priced out completely,” he said.
