U.S. ratings cut may swamp tax-free market

MIAMI Tue Jul 19, 2011 3:58pm EDT

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MIAMI (Reuters) - America's municipal bond market is feeling more heat from possible ratings downgrades of federal debt than from actual financial risks arising from Washington's debt-ceiling standoff.

Traders, portfolio managers and investment strategists broadly expect the U.S. President and congressional leaders to ultimately agree on lifting the national debt limit but are not nearly as confident that leading ratings agencies won't go ahead and cut the top-drawer U.S. debt rating.

Markets on Tuesday appeared encouraged by building interest in Washington in a bipartisan deficit-reduction program put together by a half dozen U.S. senators.

The prospect of a federal government default on August 2, when officials say the United States will have exhausted its current borrowing authority, has raised questions about delays in the massive sums transferred to states and local governments each working day.

But muni-market professional see knock-on ratings rollbacks as more likely rattling municipal bond buyers and sellers, such as cities, states and local governments which are now coming to market in far larger numbers than just months ago to finance schools, roads and other infrastructure.

On Tuesday, Moody's Investors Service added five triple-A-rated state governments to a list of candidates for possible ratings downgrades along with the United States.

Maryland, New Mexico, South Carolina, Tennessee and Virginia were put on review due to the states' high federal employment or Medicaid exposure, Moody's said.

Bonds from Virginia and Maryland, which are significant issuers of muni debt, showed no immediate reaction in secondary trading but ratings actions on muni issuers could be a big factor in coming months, according to Justin Hoogendoorn, a managing director at BMO Capital Markets in Chicago.

"There's the potential to rock the market," Hoogendoorn said in an interview. "It could dry up supply."

Ratings agencies issuing downgrades of muni issuers could reignite fears among individual investors of fiscal instability of the sort that had dogged the tax-free market for much of the past year, according to Hoogendoorn.

"From a state and local perspective, there is a very serious interest in getting the ratings resolved," Hoogendoorn said.

Trading on Tuesday in the tax-free market picked up from Monday's slow pace but still left prices mostly unchanged. Yields on top-rated 10-year bonds ended flat at 2.66 percent while 30-year yields stayed at 4.32 percent, according to Municipal Market Data, a unit of Thomson Reuters

(Reporting by Michael Connor)

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