BlackRock: Munis Face Threat of 'Super Downgrade'

Peter Hayes, head of municipals at BlackRock Inc., told advisers at the 2012 Investment Management Consultants Association in New York that he expects super downgrades to accelerate throughout the year, according to Investment News Daily.

“We're expecting a radical change in the methodology of the ratings agencies because of Dodd-Frank,” he said. One of the aspects of the Dodd-Frank Act requires ratings agencies to review their methodology for credit ratings annually.

The spreads between higher-rated municipal bonds and less-than-investment-grade ones are “dramatic,” so a severe downgrade could have a big impact on pricing, Hayes said.

Investors in municipal bonds also will have to consider the effect of likely tax policy changes, which should become clearer in the second half of the year.

As I pointed out in October:

 Obama "jobs" bill contains a retroactive tax on municipal bonds. 

The proposed jobs bill would cap municipal bond tax exemptions, which are currently 100 percent tax-free at the federal level. Americans in the top tax bracket would pay 7 percent on any income that would have otherwise been tax-exempt, including municipal bonds. If the Bush tax cuts expire at the end of 2012, the maximum tax on municipal earnings would be even higher: 11.6 percent  

Additionally, the proposal would affect previously purchased tax-exempt bonds — creating a retroactive tax increase.

It's not clear if the retroactive tax on muni-bonds will gain traction, but it might.

You really have to be a little loopy to own munis right now. There's the eventual climb in interest rates that will push the bonds down. There are the revenue problems facing some states and municipalities, which threaten the eventual payment of some bonds. There's the potential retroactive tax.  And, in addition, the likelihood of "super downgrades".