Bloomberg News

Downgraded Debt Defying Default Lures Wells Capital: Muni Credit

October 11, 2011

Oct. 11 (Bloomberg) -- Wells Capital Management is among investors buying bonds of localities whose credit ratings have been cut more than two levels in so-called super-downgrades, betting they’ll recover from the worst financial conditions in 26 years and avoid defaults.

Cities, counties and towns, whose tax income shriveled in the deepest recession since World War II, make up 24 percent of all multiple-level downgrades in 2011 compared with 9 percent in 2010, according to Municipal Market Advisors, a research firm that started tallying the ratings changes last year.

To stay solvent, localities cut costs and raised revenue. Three of five delayed or canceled capital projects in fiscal 2011 and 41 percent boosted fees, the National League of Cities said in a survey, which called fiscal 2010 the worst financially in 84 years. Local-bond defaults are only 1 percent of 2011 tax- exempt failures, which, at $1.1 billion, are a quarter of 2010’s, Bank of America Merrill Lynch data show.

Lyle Fitterer, who helps oversee $26 billion of municipal bonds for Wells Capital in Menomonee Falls, Wisconsin, said he purchased DeKalb County bonds after Standard & Poor’s cut its rating for the Georgia county, part of metropolitan Atlanta, by five levels to BBB from AA- in March. The company then withdrew the grade, citing a lack of information.

Officials in DeKalb, which saw a 20 percent decline in taxable property values since 2008, reacted to the S&P actions by passing a 26 percent property-tax increase in July.

‘Immediate Feedback’

“They got an immediate feedback,” County Commissioner Jeff Rader said of the response to S&P’s move. He said he would be “very vigorous” in boosting budget reserves.

“Often, there’s action taken to mitigate the situation,” John Dillon, chief municipal-bond strategist at Morgan Stanley Smith Barney in Purchase, New York, said about responses to multiple downgrades. “Usually management snaps to attention.”

Wells bought DeKalb parks and greenspace tax-district general-obligation bonds due in 2014 in May. That month, the yield traded as high as 3.4 percent, exceeding that of an index of BBB rated tax-exempts due in three years by as much as 1.27 percentage points, according to data compiled by Bloomberg.

The debt traded at a 2 percent yield on Sept. 20, 26 basis points more than the index at the time. A basis point is 0.01 percentage point.

“The outlook is tainted by what they see in the rear-view mirror,” Fitterer said in a telephone interview. “Unless you’re forecasting a double dip in the U.S. economy, you may see some improvement in these credits on an ongoing basis.”

Muni Yields

Ten-year tax-exempt bonds yielded 2.53 percent at 5 p.m. in New York today, according to Bloomberg BVAL Index data, the highest since Aug. 2. The yield rose by the most last week since November as municipalities increased borrowing and Treasuries declined.

Municipal securities have risen 3.9 percent in price this year, compared with 5.9 percent for Treasuries, according to Bank of America Merrill Lynch indexes.

It’s rare for municipal governments to be downgraded more than one or two levels. Moody’s Investors Service had none exceeding that in 2007, a year before the bankruptcy of Lehman Brothers Holdings Inc. collapsed credit markets.

Super-downgrades of three levels or more are driven by bond raters catching up to a municipality’s fiscal condition and are often “telegraphed” in financial statements, said Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors.

Profit in Research

An investment firm with a large research staff can profit by knowing when to sell before such downgrades, Fabian said.

“You can read the financials and you can get ahead of potential ratings changes,” Fabian said in a telephone interview.

Anne Van Praagh, managing director at Moody’s in New York, said fiscal conditions of some local governments can deteriorate more quickly now than in previous recessions. So far this year, out of 10,000 local-government bonds, Moody’s has cut seven by three grades or more.

“The credits that fall into speculative grade are the ones where you have a confluence of factors,” Praagh said in a telephone interview.

That includes lack of political will, she said. Scranton, Pennsylvania, may be an example. Its rating was cut three levels by S&P to non-investment-grade BB- from BBB- on Sept. 30 and withdrawn on Oct. 3.

The council had reduced various taxes proposed by Mayor Christopher Doherty in the city’s $70 million budget by $3 million, resulting in “a huge hit to our financials,” said Ryan McGowan, Scranton’s business administrator. The community is now facing a $6.7 million projected budget deficit, he said.

Still, Scranton’s likelihood of default stands at 0.81 percent compared with an average 2.4 percent for BB- rated corporate bonds, according to S&P data.

--With assistance from Michelle Kaske and Andrea Riquier in New York. Editors: Jerry Hart, Pete Young, William Glasgall

To contact the reporters on this story: Romy Varghese in Philadelphia at rvarghese8@bloomberg.net

To contact the editor responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net


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