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Most US municipal debt issuers could weather a period of diminished or more costly capital market access because they can control long-term debt requirements in ways that corporate and sovereign issuers cannot and relatively few rely on the markets to fund short-term operating needs, Moody’s Investors Service concludes in a new report.

Municipal issuers that would face the greatest credit stress if market conditions become more hostile are those that finance deficits through bond issuance, rely on short-term notes to finance seasonal cash flow needs, issue bond anticipation notes, or need to convert variable rate to fixed rate debt. These include some of the highest profile municipal issuers, such as the states of Illinois, California and Arizona.

The Moody’s report also addresses the related issues of recent record outflows from tax-exempt mutual funds, forecasts for lower municipal debt issuance in 2011, and the potential impact of diminished market access on municipal credit.

“Despite reports of a loss of investor confidence in municipal bonds, credit risk is only one of several factors driving investor decisions about holding municipal bonds,” said Moody’s Managing Director Naomi Richman.

Other important drivers are the impact of the expiration of the federal Build America Bond (BAB) program, extension of the ‘Bush tax cuts,’ and increasing relative attractiveness of the corporate equity markets and other investments.

Many municipal debt issuers are indeed undergoing an unprecedented level of credit stress, and Moody’s has maintained a negative outlook for all major municipal market sectors since 2008.

Should negative market commentary about municipal credit risk continue, said Richman, “diminished investor demand for municipal bonds could persist or even accelerate in the coming year.”

Moody’s expects that no state government and only a few local governments will default on Moody’s-rated debt in 2011.

There were no defaults by Moody’s-rated state or local governments in 2010, although one tax-exempt healthcare borrower did default on its debt.

Most municipal borrowers are also structurally well-equipped to weather a period of diminished market access, according to Moody’s.

Unlike most corporate or sovereign debt, almost all state and local government debt is fully amortizing, with both interest and principal payments included in operating budgets. As a result, issuers generally do not rely on the markets to roll over principal maturities.

“Most municipal debt is used to finance capital projects, and governments have the ability to defer projects if they cannot finance them at rates that make sense,” said Richman. “Even many issuers of short-term cash flow notes could draw down their available cash reserves, if necessary, to handle seasonal cash flow imbalances.”

Debt service is also a relatively small portion of most governments’ budgets. Yields could increase quite a bit and still remain relatively affordable by historical standards.

Exceptions to this rule are the small portion of state and local governments that issue long-term debt to fund current operations.

“Reliance on deficit financing is one of the reasons that California, Illinois and Arizona are the three lowest-rated states,” said Richman

There could also be pressure from diminished market access on issuers who have no alternative to short-term notes to finance seasonal cash flow needs, and for issuers of bond anticipation notes for interim construction financing. It could also be a hardship for an issuer seeking to convert outstanding variable rate demand bonds to a fixed-rate mode.

“Even for those issuers most exposed to market risk, we anticipate that they will still find ways of meeting their funding needs, and that defaults will remain rare,” said Richman.

For details see the full report Municipal Market Investor Confidence: Linkages to Credit Quality

Source: Moody’s Expects Only a Few Municipal Bond Defaults in 2011