With credit-rating agencies under fire for their role in the global financial meltdown, can investors trust their ratings of municipal bonds?
We’ve been asked that question many times lately, and for good reason. Investors have relied on municipal bond ratings since S&P began assigning them in 1916. In fact, the widespread use of ratings has fueled the growth and popularity of municipal bonds. Ratings have allowed investors in one city to better relate to the credit quality of bonds issued in others. Historically, markets for municipal bonds tended to be regional. Bond ratings, as trusted opinions from an independent source, allowed municipal bonds to be traded nationally. This is important because unlike stocks, municipals don’t trade on a central exchange.
Recently, as a result of Senate hearings on their role in rating debt backed by sub-prime real estate, the spotlight is on the rating agencies themselves, leading investors to question whether municipal bond ratings should also be called into question.
Not long ago, Moody’s and Fitch announced “recalibrations” of their muni ratings to bring them in line with their corporate counterparts. This action was widely seen as recognition that municipal bonds, with their extremely low default rates, were rated too low in comparison with much riskier – but higher rated – corporate bonds.
The sub-prime crisis
Public perception placed at least part of the blame for the sub-prime crisis on competition among rating agencies for market share, and the resulting pressure to deliver the ratings the investment banks wanted.
For muni investors, it’s important to know whether practices by the agencies could cause a similar catastrophe in the municipal bond market, and if their ratings can be trusted.
How the rating process differs
The bonds at the center of the sub-prime meltdown were “structured” products. Unlike a traditional municipal bond, structured bonds have no issuing “entity,” such as a local government, hospital or other responsible party seeking to raise capital from the sale of bonds for traditional purposes. Rather, structured bonds represent slices of large pools of underlying financial assets. Each slice contains hundreds or thousands of mortgages whose mortgage payments are used to make principal and interest payments on the bonds.
Municipal bonds, on the other hand, are issued to fund capital needs such as buildings, or water and sewer projects for either governmental entities or qualifying non-profits. There is usually a security interest in the project pledged to bondholders.
This difference is key. Structured ratings try to statistically predict the likelihood of default, based on historical loan performance data. Municipal ratings are indicators of relative credit quality, rather than default predictors. Few municipal bonds ever default, and those that do, are typically unrated.
Municipal bond ratings provide a guidepost to investors as to which bonds are likely to be more economically sensitive, have greater revenue or expenditure challenges or have stronger or weaker security pledges in case a default does occur. All bonds rated “BBB-/Baa3” and above are considered “investment grade,” meaning they are expected to meet their debt service obligations in full and on-time. Average ratings for state and local governments respectively, are in the “AA/Aa” and “A” categories.
The rating process
Contrary to public perception, rating agencies do attempt to maintain independence and neutrality in the rating process. Ratings are done on request by the issuer, who then cooperates in providing required financial information and other data needed in the rating process. S&P assigns two analysts to each rating, a primary and “backup” analyst. The primary analyst is expected to develop a formal rating presentation and rating recommendation that is presented to a rating committee composed of senior analysts. After discussion and voting, a rating is assigned and communicated to the issuer. The issuer can appeal the rating, but only by presenting new information not available at the time of the initial rating decision.
Shielding the rating process from outside influence at S&P is accomplished by committee decision procedures. It would be close to impossible for a compromised analyst to overcome the committee process since the assignment of a rating is ultimately out of the analyst’s hands. A rating recommendation substantially at variance with other similar credits would raise eyebrows.
Although rating agencies are paid fees by issuers for ratings, fee setting is separated from the analytical process and is determined by a separate staff. Analyst compensation is not based on the volume of ratings done or new business originated.
Like any business, senior management within the rating agency is expected to generate earnings that please its public owners (Moody’s) or corporate parent (S&P). While analysts often participate in the rating of new products, their compensation is not tied to product development and they are not compensated on business production, but rather on quality of analysis, committee participation, and other rating quality related evaluations.
Getting it right
Clearly, while ratings are assigned appropriately most of the time, there are instances where the rating process, no matter how rigorous, can end with an errant conclusion. Either the rating criteria were wrong or misapplied, important but unknown information was not supplied to the analyst, or judgment of the analysts and committee were just inaccurate.
A healthy, properly staffed surveillance process will usually catch these problems. Fortunately, in the municipal bond sector, the glaring mis-calls have been few, and the market has remained confident in the vast majority of rating decisions.