Does a downgrade cost anything?

August 19, 2011

The debt of the United States was downgraded by Standard & Poor’s several weeks ago, but the price of U.S. Treasuries have skyrocketed since then. This confuses many people because a baseline relationship in the fixed-income markets is that lower-rated, less-creditworthy bonds will be relatively cheap and investors will demand higher interest rates to compensate for additional risk.

To see this bond market truism, it’s much more instructive to look at the downgrade of the debt of New Jersey. Fitch lowered the state’s credit rating Wednesday citing heavy debt and benefit obligations. This followed downgrades by Moody’s and S&P earlier in the year. Municipal bond and credit default swap markets didn’t like this third downgrade and did what you would expect them to do: they required more yield in the case of cash bonds and more payment in the case of credit default swaps.

The graph above charts muni CDS prices for New Jersey (data supplied by Markit). You can see the move up in CDS prices began in June when Governor Christie and the state legislature made the final run to their agreement on the fiscal 2011 budget, which began on July 1. The uncertainty and contentiousness of the process must have spooked investors and dealers.

The most widely-used measure of credit risk for municipal bonds is the Thomson Reuters Municipal Market Data (MMD) AAA GO Scale. MMD’s Daniel Berger in his daily note talks about how New Jersey bonds got riskier and cheaper ahead of the downgrade and suggests that cash-bond selling started happening ahead of the Fitch downgrade.

New Jersey has approximately $31 bln of appropriation backed-debt and $2.6 bln in GO [general obligation] debt. The spread of New Jersey’s 10yr GO bonds has steadily risen this past week and closed last night at +47bps to MMD’s AAA GO scale. Last Friday this spread was +40bps.

It looks as if traders were anticipating this move by Fitch and this confirms our thesis that spreads are a leading indicator of credit. For the latest 12-month period this spread averaged +56.3bps which ranks sixth highest among the states actively monitored by MMD.

The MMD chart perfectly shows how traders and investors responded to rating downgrades and how they demanded higher interest rates starting September 22, 1010. This was the date that Moody’s put New Jersey on “negative outlook,” the advance notice of a possible downgrade. The long, flat, tabletop-like area is the period of market confusion following Meredith Whitney’s pronouncement of default doom. Markets settled down after that with a decline in New Jersey’s risk profile before turning up again ahead of Fitch’s downgrade.

MMD data on cash bonds and Markit data on municipal CDS don’t track each other perfectly but they both show the market demanding higher interest rates on New Jersey’s debt and higher prices on default insurance with each downgrade. It’s a snapshot of the cost of increased risk. Downgrades do cost something.

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