The U.S. municipal bond market has been impacted by the volatility of tight credit conditions, federal regulation and stimulus as much as, if not more than, other sectors. What makes state and muni markets unique is how much remains unknown relative to corporate markets about their ability to recover. Depressed consumer spending, declining housing prices, job losses and high pension costs have created their most serious fiscal challenges in decades. The declining revenues combined with ongoing spending pressure to fund social services and critical infrastructures have contributed to large state budget shortfalls for fiscal years 2009-2011. Federal stimulus has been a net beneficial impact on stressed states and muni issuers so far, but unless states move to balance their budgets now, real credit risk will remain when the stimulus effect runs out. Adding to this pressure, the diminished access to credit markets and the collapse of credit enhancement tools only drive up their cost of borrowing. If that is not enough, high volatility and limited credit access have taken away banks’ desire to support variable debt obligations, increasing the costs and risk of variable rate and interest rate swaps. We expect NRSROs to make good on warnings to issue negative rating actions steadily on select munis for the next several years.
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