Moody’s Investors Service will recalibrate long-term state and local municipal bond ratings to enhance the ability of investors to compare quality across a spectrum of bond investment alternatives. Previously, Moody’s published separate ratings scales for state and local municipal bonds and a global rating scale for sovereign, sub-sovereign, financial institution, project finance, structured finance and corporate obligations. The reasoning for the change is that municipal credits have a historically low default rate, and the dual system resulted in a perceived penalty for issuers in the form of higher borrowing costs or interest rates paid by the issuers. Moody’s employed the old scale for rating municipal credits since 1918. According to Moody’s, there are approximately 18,000 state and local government entity bond issuers, with security combinations covering nearly 70,000 ratings.
The recalibration of ratings began on April 16, 2010, and is expected to conclude by May 10, 2010, as this article goes to press. According to Moody’s, recalibrated ratings will include “change in scale” in the ratings history of the bond. Also, the revised rating will normally include the letters GSR during the recalibration period. It needs to be stressed that “market participants should not view the recalibration of municipal ratings as rating upgrades, but rather as recalibration of the ratings to a different scale.” The recalibration will align municipal ratings with their global scale equivalents. However, the ratings for some sectors will not change. The following summarizes Moody’s conclusions by broad municipal sectors:
“State and local government general obligation ratings: will change by an average of about two notches higher than their current ratings on the municipal scale, with a range of zero to three notches. Ratings at or above Aa3 on the municipal scale will receive less upward movement than those rated below Aa3.
“State and local government sales and special tax obligations: generally will move up by one notch. These obligations are typically secured by broad general sales taxes, and narrower restricted-use taxes such as hotel and gas taxes. Special tax-pledged revenues are generally more volatile than other broad-based tax revenues and the issuer often has less control in setting the tax rate associated with pledged revenues. Therefore, debt ratings secured by these revenues will receive less lift in the recalibration than general obligation ratings.
“Housing, healthcare and other enterprise sectors: most will not change because they are already well-calibrated with the global scale. Those enterprise credits that do change will move up by one notch.”
The rating agencies have been under political pressure since many subprime bonds were rated AAA and defaulted, while lower-rated municipal bond credits have not experienced significant defaults. Municipal issuers believe their credits, decidedly stronger in quality, through the same time period, should have received higher ratings than assigned, which would have resulted in lower interest costs for the issuing entities and ultimately the taxpayers. Unlike issuers of corporate debt, most municipal issuers have the ability to raise fees or taxes to pay principal and interest maintenance on outstanding debt. Issuers of essential purpose municipal utility debt such as sewer systems and electric utilities, do not have taxing authority, but are the only game in town when it comes to these aptly named critical services. Importantly, the default rate on good quality municipal bonds has been extremely low historically. However, as we are learning in spades through this economic downturn, history is not always an accurate predictor of future events.
Concerning insured municipal bonds, as has been the case, a rating for the issuer, based on the strength of the guarantor company, and a rating based on the underlying credit (if applied for) will be issued. Going forward, being consistent with other recalibrated municipal ratings, the Global Rating Scale will be denoted with a capital G adjacent to the rating assigned by Moody’s. As has always been the case with insured municipals, the underlying rating of the issuing credit is what truly matters most. With the recent widespread problems that have occurred in shocking degree, clearly, not all AAA-rated bonds are the same, particularly as it relates to credit enhancement. Therefore, in prudence, our due diligence on municipal credits is more important than ever.
John D. Jones is senior vice president in the Capital Markets Group at Country Club Bank, Kansas City.
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