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How safe are your munis?

August 11, 2011, 6:30 PM UTC

The S&P downgrade machine cut through the U.S. municipal bond market earlier this week, stripping thousands of securities of their coveted triple-A credit rating. While on the surface the pruning of the muni space looked extensive, it turns out that it was anything but comprehensive. For now, the rating agencies are waiting to see what Congress does when it meets next month to slash excess fat off the federal budget. If states and local governments are forced to absorb the brunt of the cuts, expect to see a far greater list of downgrades in the next few months.

The bonds that were downgraded this week were largely those that are intrinsically linked to U.S. Treasuries, making their credit step down a no brainer. Analysts were scratching their heads as to why S&P even waited a whole trading day to issue this downgrade as the securities in question trade virtually in lockstep with Treasuries.

S&P did not specify the cumulative value of bonds it downgraded on Tuesday, nor did it go into detail on any specific downgrade in the group, telling Fortune that it does not comment on individual downgrades. Nevertheless, Moody’s (MCO) said in a report last month that there were around 7,000 municipal securities that were backed by Treasuries, worth around $130 billion.

If S&P was consistent in its analysis, then the scale of the downgrade should come out more or less in line with the estimate from Moody’s, meaning that just 4% of the $2.9 trillion muni market saw a downgrade yesterday. And since these bonds trade mostly on par with Treasuries, that would mean their yields actually fell on the downgrade as people sought shelter from the volatile markets.

What didn’t happen was a mass downgrade of states and local governments. There was concern that S&P would ignore the balance sheets of the triple-A rated states and municipalities and apply what analysts refer to as the “sovereign ceiling,” which states that local governments cannot have a credit rating that is higher than that of the national government.

But S&P went out of its way in a note to investors late Monday to explain why it believes there are instances where it is possible for local bonds to have a higher credit rating than the central government.

“We believe that certain state and local governments have historically shown a greater commitment to fiscal discipline or a more resilient local economy, which may be reflected in ratings higher than that of the U.S. government,” S&P said in its note to investors Monday. In a minority of cases (3.9% of U.S. public finance ratings), state and local governments currently demonstrate what we consider to be particularly strong credit characteristics consistent with our highest rating and, thus, are rated ‘AAA’.”

S&P acknowledged state and local governments in the U.S. have far greater power to tax and spend when compared with other countries where the money usually trickles down from the capital city. But S&P also said there was a limit as to how large the differential can get – only one notch. So if the U.S. is downgraded again in the next 12 to 18 months, then there will no longer be any triple-A rated muni bonds in the U.S.

But just because S&P didn’t issue any major state or local downgrades this week doesn’t mean that the market is in the clear. There are currently around 60,000 muni bond issuances trading at the moment, each with its own bespoke financial blueprint – some sound and some troubled. Cracks in the fiscal regime of some of those issuing entities will probably cause S&P to move in and slash their ratings.

To be sure, a rating downgrade does not mean that a default is imminent. Muni bears would like to link the two, but being rated one or two notches below triple-A doesn’t mean the next stop on the train is Default City. An AA+ rating still implies a very low risk of default.

Meredith Whitney, the outspoken Wall Street banking analyst who formed her own shop during the financial crisis, rocked the muni market at the end of last year by predicting that 2011 would bring 50 to 100 “sizable” defaults in the muni market in 2011. While we have yet to see any “sizable” muni default this year, there could be a number of sizable downgrades, which could eventually lead to some defaults down the road.

Those bonds most at risk of a downgrade are those that depend on the federal government to supply a large portion of their revenues in the form of transfer payments or block grants. While the U.S. does have a decentralized government, there are some states and communities that depend more on federal government transfers than others. States that have high Medicaid obligations and municipalities that depend heavily on military spending are a couple of examples of the type of issuers that could receive a nasty note from S&P. (See 5 states at risk in the debt ceiling debate)

The rating agencies will be watching which programs Congress moves to cut in the next few months and will be matching it up with the communities that they believe will feel the most pain. Those that could see a big hole in their budgets as a result of the cuts will be ripe for a downgrade.

In a way, Congress has effectively passed the buck to the state and local governments in regards to taxes, forcing them to raise the revenues at local level. One of the reasons S&P downgraded the U.S. last week was because of the political deadlock that resulted from the debt ceiling debates over raising revenue. Many state and local governments will now be facing similar debates as Congress moves to slash spending.

They would be wise to learn from Congress’s bungling and work out an effective compromise. Failure to do so could mean an uncomfortable visit by S&P.