Preparing for Moody's Revamp of Muni Ratings

Bowing to significant political pressure, Moody's is set to change the way it rates municipal bonds. The change will result in thousands of upgrades, some perhaps many letter grades higher.

Historically, Moody's municipal bond ratings talked and walked like its ratings for other types of bonds: corporates, asset-backeds, etc. The top rating was Aaa, the lowest investment grade rating was Baa3, and so forth. But the default and recovery performance of municipals has been vastly different from those of other bond categories.

For example, according to Moody's, between 1970 and 2006, about 1.3% of A-rated corporate bonds suffered a default within 10 years of issuance. However, only 0.03% of A-rated municipal bonds suffered defaults over the same time period. The ratings results were not even consistent within municipal bonds. Among Moody's rated general obligations (bonds backed by the full taxing power of a city, county, school district or state), there was exactly one default from 1970 to 2006, whereas 0.4% of other municipal bond types defaulted.

Moody's has acknowledged that its municipal ratings aren't comparable to corporate or asset-backed securities ratings. However, in the past Moody's had contended that municipal bond investors appreciated the gradations of credit quality afforded by the municipal ratings scale. If Moody's used nothing but default expectation, virtually all general obligation municipals would be rated Aaa. It stands to reason that municipal investors value the differential between A1-rated California, Aa3-rated New York and Aaa-rated Virginia. Something would clearly be lost if all three were rated Aaa.

Behind the Move

However, recent stress in the municipal bond market has brought politics into the discussion. From auction rates to bond insurers, the perceived safety of municipals has taken a hit. The collapse of several tender-option bond programs (a popular hedge-fund strategy involving municipals) has dented demand for munis. More behind the scenes, municipalities are finding Wall Street less hospitable than in years past. Bond insurance and bank letters of credit have become considerably more expensive. Wall Street firms are not as willing to buy bonds for their own accounts, increasing the cost of issuance.

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Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment adviser in Baltimore, Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.