Any television viewer is familiar with infomercials that tout the latest and greatest products. In many cases, the product is nothing new but simply an existing product with a fancy twist or a space-age polymer that supposedly makes it better. The end result is debatable. A fresh coat of paint to a quality original can often be a better alternative. In that vein, both Moody’s and Fitch, two of the three primary bond rating agencies, will be assigning higher ratings to a significant number of Municipal Bonds starting in April. The ratings changes are a result of both rating agencies migrating Municipal Bonds to their Global Rating Scale whereby Municipal Bonds are rated with similar criteria as Corporate Bonds and government bonds. Both Moody’s and Fitch have expressed the changes should be viewed as a “recalibration” rather than “upgrades”. The two ratings agencies will be using similar, but not exact, methodology in recalibrating bond ratings.
General Obligation (GO) and essential service revenue bonds may benefit the most with ratings subject to being upwardly revised up to three “notches” (a notch corresponds to an incremental move from A2 to A1, for example) from Moody’s and up to two notches from Fitch. Moody’s also stated no state GO would be rated below A1. This indicates that the State of California, the poster child for municipal budget woes, will receive a three-notch higher rating than its current Baa1. Factoring in changes from Fitch, State of California GO bonds, currently rated Baa1, A-, and BBB, from Moody’s, S&P, and Fitch, respectively, will soon be rated A1/ A-/A-.
Standard and Poors (S&P), the other major rating agency, has stated for some time that its current Municipal Bond rating criteria are already comparable to other types of bonds and therefore no systematic, formal changes will be forthcoming. However, S&P has indicated that it has gradually adjusted selected municipal bond ratings over the past several years for their historically lower rate of default. According to Municipal Market Advisors (MMA), S&P has upgraded 8700 Municipal Bonds over the past few years with approximately 2000 taking place in 2009 despite the adverse economic conditions.
The motivation for Municipal Bond ratings change stems from studies conducted by all three rating agencies that, over the long-term, default rates were lower for Municipal Bonds compared to comparably rated corporate bonds [Table 1]. Both Moody’s and Fitch planned to implement the changes in 2008 but delayed due to the financial crisis.
Not all Municipal Bonds will have their ratings recalibrated. Both Moody’s and Fitch will not be adjusting ratings from bonds issued by the following municipal sectors: housing, healthcare (hospitals), airports, private schools, toll roads, and other municipal infrastructure-related enterprises. Moody’s and Fitch stated that bonds issued from these sectors are already correctly rated for their underlying creditworthiness compared to their corporate counterparts.
Moody’s and Fitch differ slightly on below Investment-Grade, or High-Yield Bonds. Moody’s will not be adjusting the ratings for bonds already rated below-investment grade while Fitch may adjust Non-Investment-Grade rated bonds on a “case-by-case” basis.
Neither Moody’s nor Fitch has specified how many bonds will ultimately receive higher ratings. As mentioned, S&P has upgraded thousands of municipal bonds over the past few years and since Moody’s rates approximately 70,000 individual bonds from 18,000 different issuers, the number of changes could be in the thousands. Fitch will have their recalibration complete by April 30 while Moody’s will finish in early-to-mid May.
According to Moody’s and Fitch, for those bonds that do not receive a higher rating, the outlook, which refers to a longer-term 6 to 18-month potential ratings direction, may be revised higher. We view the ratings changes as a vote of confidence for Municipal Bond credit quality. Given all the scrutiny the ratings agencies have taken over the past two years, the decision to move forth with ratings reform refl ects a certain degree of confidence internally at both firms. To be sure, the ratings agencies have been under political pressure with both state officials and politicians declaring municipal bond rating criteria as overly harsh. They argue the lower than-warranted ratings have led to increased borrowing costs and exacerbated state budget challenges. While the rating agencies have justifi ably received criticism for ratings on complex bonds backed by residential mortgages, the default statistics shown earlier, whereby default rates trend lower for higher rated bonds, support the process used for Municipal and Corporate Bonds.
Both Moody’s and Fitch acknowledged that many state and local borrowers remain under financial stress but also cited their greater flexibility in taking necessary actions to service their debt obligations. Moody’s expected overall defaults to “remain low” while Fitch expected defaults to remain relatively “isolated occurrences”. The market may take some time to assimilate the changes but we believe this is another positive for municipal bond investors. Nonetheless, market reaction has been negligible so far, as last week Municipal Bonds reacted more to a pickup in new issuance and Treasury market weakness. The news also had little impact on institutional investors since they already firmly believed in the better inherent credit quality of municipals and placed less emphasis on the face value of ratings. However, we believe the news is an endorsement of Municipal Bond credit quality and may help day-to-day trading, or liquidity, in the municipal market. Additionally, investors subject to minimum rating criteria that limited purchases to bonds rated single-A or higher for example, will now have a broader pool of bonds to choose from. Greater market participation helps smooth out market swings up or down and may help reduce volatility.
Investors might be better off turning off the TV and taking those gloomy Municipal Bond stories with a grain of salt. The latest and greatest might not be all it’s cracked up to be and a new look on the original can be a welcome sight. In addition to a favorable supply/demand balance and the prospect of higher tax rates, we believe municipal rating reform is a positive for the municipal market.
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your fi nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fi xed rate of return and fi xed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
- Mortgage Backed Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
- High-yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversifi ed portfolio of sophisticated investors.
- The market value of corporate bonds will fl uctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertise yield.
- Municipal bonds are subject to availability, price and to market and interest rate risk is sold prior to maturity.
- Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax.
- Federally tax-free but other state and local taxed may apply.