Municipal Credit Ratings Set to Rise
April 28, 2010
By: Steve Shutz, Vice President

In recent weeks, two of the three primary credit rating agencies, Moody’s and Fitch, announced plans to move forward with their respective rating recalibration processes that were sidelined during the height of the credit crisis in 2008. This will result in rating increases for tens of thousands of municipal bonds as the agencies attempt to rate municipals on a comparable scale with corporate and sovereign debt. S&P asserts that it already employs a ‘global’ rating scale, but has been revising municipal ratings upward in large numbers over the past several years¹ .

Traditionally, municipal bonds have been rated on a separate, more rigorous scale than corporate bonds. The basis of the separate scale was to provide municipal investors with more granularities when comparing individual credits within the municipal bond universe. While this approach does provide some value to investors, lawmakers and issuers have long argued that it unfairly pushes municipal financing costs higher than they should be.

The rating improvements should not be viewed as upgrades, but rather as confirmation that municipal bond ratings, in general, were too low in comparison with ratings in other credit sectors.

Political Support
After remaining dormant on the topic for nearly two years, Moody’s announced plans in March 2010 to move forward with their Global Rating Scale (Fitch followed shortly thereafter). The announcement came a day after Senate Banking Committee Chairman Chris Dodd (D-Conn) unveiled a financial regulatory reform proposal that would effectively mandate this recalibration. It is very likely that the timing of Moody’s announcement the following day was no coincidence.

The little-noticed provision in Chairman Dodd’s bill would force the Securities and Exchange Commission (SEC) to require all nationally recognized rating organizations to rate securities on the likelihood of loss to investors – consistently across all sectors of the bond market. This is of particular benefit to the ratings for municipal bonds. Not only have municipal bonds experienced fewer defaults than corporate bonds² , but when a muni default does occur, recovery rates are far stronger than those of corporate issuers.

Mapping Munis to the Global Scale
The upward shift in ratings will be concentrated in general obligation (GO), essential service revenue, and special tax sectors of the municipal market. Low investment grade (Baa-rated) general obligation issues will see the most significant adjustments, improving by as many as 3 notches by Moody’s and 2 notches by Fitch (Tables 1 and 2, respectively).

These rating adjustments are much more conservative than the original upgrades proposed in 2006. Moody’s original “mapping” of municipal credit ratings to global scale ratings proposed upgrades as large as 9-notches up the rating scale for non-investment grade GOs. The original mapping also included a much wider breadth of muni sectors – non-essential revenues like healthcare, tobacco, and industrial development for example.
It is no surprise that both Moody’s and Fitch chose to water down their original proposals given the scrutiny that their ratings have received – most notably the questionable AAA ratings given to securitized investments.

Even in its watered down form, a corporate equivalent rating scale for municipal bonds will be a welcome improvement for investors who need to analyze credits across many sectors of the bond market.

Market Impact
Although these rating increases do not actually reflect credit quality improvement, the perception of improvement should provide a well needed confidence boost to the retail investors who make up two-thirds of the marketplace. If nothing else, the recalibration should provide retail investors with an education in the default history of municipal bonds, and add some perspective to the fear mongering recently brought on by mainstream media.

Institutional investors do their own research on these credits and rely far less on the ratings given by Moody’s, S&P, and Fitch. However, many institutional investors allocate their muni portfolios among certain credit rating categories based on either internal policies or external regulations. Money market funds, for example, must comply with SEC rule 2a-7 which limits the securities that a fund can own based on maturity, liquidity, and credit quality. As bonds are recalibrated into higher rating categories, there will be a larger universe of funds to invest in those bonds.

It is not our expectation that these rating revisions will cause the “upgraded” bonds to experience an immediate re-pricing higher in the market. It is more likely that there will be a transition period where more sophisticated buyers will continue to “look back” to prior ratings. However, over time the sheer number of upgrades will make it very challenging for individual investors to discern the relative strength between the “old” and “new” ratings. Eventually the prices on most bonds will converge with the higher prices in the new rating category.

Portfolio Strategies
In our view, the biggest beneficiaries of the rating recalibrations will be those credits that have “upgrades” that cross a letter-grade boundary (i.e., from A to Aa). The current spread on A-rated credits are +75/Aaa, versus only +20/Aaa on an Aa-rated bond, this represents a 55 basis point differential between the two rating categories.

There is a clear advantage to adding exposure to an A-rated bond that will migrate to the Aa category. CCM has been adding A-rated essential service revenue (ESR) issues to portfolios. ESR’s are municipal credits backed by a revenue source that provides an essential service to the public (i.e., water/sewer, public power, transportation, public education). These credits will benefit from the recalibration, but do not face the same fiscal pressures widely afflicting state and local governments.

It is also unlikely that all of these upgraded municipal credits will benefit from this shift equally. Many higher profile issuers like California State or Illinois State will continue to deal with wider spreads as the market remains well aware that recalibration will not cure their fiscal problems.
While it is likely that the rating recalibrations will provide support for the broad municipal market, we feel that credit selection and diversification remain essential. In some cases it will make sense for residents of high tax states, like Maryland, to buy out-of-state bonds that may get a bigger boost.

Credit ratings are an essential tool in the municipal marketplace. The sheer number and diversity of issues requires the credit evaluation and surveillance that rating agencies provide, especially for retail investors. At CCM, we will continue to emphasize our internal credit analysis to seek value for our client portfolios during this transition.

TABLE 1 – Moody’s Recalibration Map:
(18,000 issuer upgrades for approx. 70,000 security level ratings)

Source: Moody's Investor Service

TABLE 2 – Fitch Recalibration Map:
(38,000 security level rating upgrades)

Source: Fitch Ratings

Endnotes:
¹ S&P has upgraded over 9,600 municipal bonds since 2001 as a result of “criteria changes”. These changes represent a stealth upgrade of the municipal sector to criteria that is consistent with other sectors of the bond market. The upgrades have been experienced over time, not the shotgun approach that Moody’s and Fitch will initiate in April 2010.
² Rating agency default studies show that investment-grade municipal bonds as a group have a lower default rate than “AAA” rated corporate bonds.

Source: Moody’s Investor Service