By Ty Schoback and Michael Taylor, Senior Analysts, Tax-Exempt Fixed-Income Research
In 2010, public ratings agencies upgraded en masse, or “recalibrated,” tens of thousands of municipal bonds without without a formal review of each obligor’s underlying credit characteristics.
Recently, Moody’s and S&P announced new revisions to their General Obligation (GO) rating methodologies. S&P’s revision is anticipated to result in an upward migration of their local GO ratings (60% unchanged, 30% upgraded, 10% downgraded), while Moody’s revision is widely anticipated to result in a downward migration of local GO ratings.
The challenge with methodology revisions is that, generally speaking, there is no fundamental change in the credit/risk profile of the affected credits — simply a change in the rating agencies’ weighting of credit fundamentals.
Given public rating and subsequent price volatility, thorough and independent credit research has become critically important for municipal bond investors.
It has been just over three years since Moody’s and Fitch Ratings upgraded en masse, or “recalibrated,” tens of thousands of state and local government general obligation and revenue bond ratings to the so-called Global Ratings Scale (GRS)*. Supported by historically low default statistics relative to other fixed-income asset classes, state and local government officials successfully argued that their respective governmental entities were underrated compared with corporate peers, and, as a consequence, were paying higher yields.
In hindsight, the ratings recalibrations created confusion, increased market volatility, diluted municipal rating granularity and the value of ratings as a pricing tool, and ultimately highlighted the importance of bottom-up independent credit research. Today, three years after the initial recalibrations were implemented, it seems as though the agencies are continuing to refine their rating methodologies. Are the rating agencies shifting the goalposts (again)?
There are many types of municipal bonds offering a wide disparity of credit quality and commensurate yield levels to compensate for the various degrees of credit risk. Responsible investment practice requires an appropriate assessment of credit risk and ensuring adequate yield compensation for the level of credit risk taken with any investment purchase. For example, it would not be prudent to purchase an investment offering a yield commensurate with a AA rating, when the true credit profile is more in line with an A rating. It is important not to overpay for an investment due to a misguided understanding of true credit risk. Investors relying exclusively on public ratings that are increasingly volatile would understandably have a difficult time gleaning appropriate yield compensation for actual credit risk.
Columbia Management does not disagree with the intent to bolster the transparency and predictability of public ratings. However, when the process results in increased market uncertainty and volatility, investor confidence in public ratings is undermined. No investor wants to see the value of his or her portfolio erode overnight due, in part, to a methodology revision that lowers the public credit rating. The challenge with methodology revisions is that, generally speaking, there is no fundamental change in the credit/risk profile of the affected credits — simply a change in the rating agencies’ weighting of credit fundamentals. However, it is possible the market could perceive something has changed, potentially contributing to lower valuations and reduced liquidity.
It has become increasingly challenging for even sophisticated investors to purchase individual bonds given public rating and subsequent price volatility. A credit-driven municipal market remains a relatively new concept, as the market was largely commoditized by AAA monoline insurers through 2007. Given the continued uncertainty around agency ratings, combined with an ever-increasing focus on credit risk in a time of sequestration and federal and state funding changes, we believe that the case for thorough, consistent and independent credit research is compelling.
For an in-depth analysis, please read the white paper: Agency rating volatility: Municipal recalibration and beyond
*Standard & Poor’s, while not formally recalibrating its ratings scale, implemented several rating criteria/methodology changes that resulted in upgrades vastly outpacing downgrades over a similar period.
Ratings range from Aaa (highest) to D (lowest), represent the ratings agency’s relative and subjective opinion and are not absolute standards of quality. Investments are subject to market risk regardless of their rating.
Income from tax-exempt municipal bonds or municipal bond funds may be subject to state and local taxes, and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal income tax rules will apply to any capital gains.
There are risks associated with an investment in bond investments, including the impact of interest rates, credit and inflation. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer term securities.