Fixed Income: Municipal Bonds
Credit ratings represent the general credit quality of a bond issue by grading the likelihood of timely payments of principal and interest on the bonds. The lower the rating, the greater the indication of risk of a payment default. Rating trends of upgrades and downgrades for individual issues and/or sectors in the municipal bond market can help investors identify improving and declining risk profiles over time. Municipal market participants rely heavily on these indicators of risk when they determine the relative value of municipal investments.
THE ROLE OF CREDIT RATINGS
The credit rating scale represents a consistent framework for ranking and comparing the relative risks of debt issues.
Because ratings are a reflection of credit risk, they have an important effect on a bond’s price and yield in the market.
Securities with higher credit risk have higher yields to compensate investors for the additional financial risk. The market price for a bond will react to rating changes, as an upgrade or downgrade will communicate a lesser or greater amount of credit risk, respectively, resulting in a corresponding decrease or increase in yield. While ratings help determine the value of a bond in the market, ratings do not represent a recommendation to purchase, hold or sell a security. They can, however, be used to identify relative value in the market when comparing interest rate spreads among or between rating categories. For example, benchmark yields on five-year general obligation (GO) bonds show that a single-A rated bond is priced to yield
3.76 percent, or 29 basis points more than an uninsured triple-A rated bond yielding 3.47
percent. This is near the average spread over the past year.
Because more than half of the new municipal bonds issued now come to market rated triple-A with bond insurance, there are fewer bonds that continue to show an outstanding underlying rating. While many believe that the triple-A rating because of credit enhancement is all an investor needs to know about the credit quality of the bond, some investors believe that understanding the underlying credit ratings of the bond issue helps them assess the overall quality and diversification of their portfolios. Fewer outstanding underlying ratings will offer fewer opportunities to assess improving or declining trends in the underlying credit quality of insured bonds.
there is a general parallel rating structure. A split rating, or one where the rating agencies do not arrive at the same rating for an issue, reflects differing opinions on the outlook for a bond issue. Because of the essential role credit ratings play in the bond market, the credibility of the rating agencies rests on their ability to be independent and objective in issuing their ratings opinions.
THE RATING PROCESS
In assigning a rating to a new bond issue, the rating agencies make an assessment of the national and local economy, the debt characteristics of the issuer and the legal structure and security for the bonds, among other things.
Standard & Poor’s believes that the foundation of a community’s fiscal health is its economy. Analysis of demographics, tax base and the blend of agricultural, industrial and service sectors of the economy help identify the strength of the local economic base. Other factors considered in the rating process will depend upon whether the rating is for a general obligation bond or a revenue bond. General obligation bond credit quality centers on the general taxing power of the community, while revenue bonds have specific revenues backing the credit.
General Obligation Bonds
• administration
: When an issuer sells a GO bond secured by its full faith, credit and taxing power, it is offering its broadest pledge to levy an unlimited tax such as an ad valorem property tax, or sales or income tax, in order to ensure timely repayment of the bonds. GO rating analysis focuses on:
• historical and projected economic conditions
• financial performance and flexibility
• debt burden
THE RATING AGENCIES
Moody’s Investor Service, Standard & Poor’s and Fitch
IBCA are the three rating agencies that provide credit ratings for municipal bond issues. Although rating criteria and methodology vary slightly among the rating agencies,
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Fixed Income: Municipal Bonds Page 2
Higher income levels and a diverse economic base are generally indicators of superior debt repayment capabilities.
Revenue Bonds: Unlike GO bonds, revenue bonds are generally backed by the revenue stream of the project financed with the bond proceeds. The critical points of analysis of a revenue bond are:
• the demand for the project
• legal protection for the bondholders in case demand declines or the project otherwise does not produce sufficient revenues as projected to meet debt service
Competition between providers of the same service is more likely to be a rating factor in revenue bonds than in GO bonds because of the types of projects financed, such as multifamily housing, hospitals, universities and toll roads. These projects can face competition in varying degrees from other public and private entities, which introduces a credit risk not normally associated with general obligation financings for projects such as government buildings. The rating agencies have specific criteria for rating each type of revenue bond, as the risk factors for a community hospital will be different than the factors for a new toll bridge, for example.
THE LONG-TERM ISSUE RATING SCALE
Debt rated triple-B or higher is considered “investment grade,” which indicates that the payment default risk is relatively low and timely payments are probable. Debt rated below triple-B is considered predominantly speculative as to the issuer’s capacity to make payments in accordance with the terms of the obligation. Ratings below the triple-B threshold are also known as “non-investment grade.”
Bond ratings play an important role in the municipal bond market by helping investors interpret the relative credit risk of their investment holdings and opportunities. Municipal bond investors should periodically review the credit ratings of their portfolios to confirm that the bond credit quality suits their risk tolerance and stated investment objectives.
For issues with an original maturity of longer than 12 months, the following rating scale applies:
THE LONG-TERM ISSUE RATING SCALE
INVESTMENT GRADE
MOODY’S* S&P** FITCH IBCA** BOND QUALITY
Aaa
Aa
AAA AAA
AA AA High Quality
A
Baa
A
BBB
A
BBB
Upper Medium Grade
Medium Grade
NON-INVESTMENT GRADE
MOODY’S* S&P** FITCH IBCA** BOND QUALITY
Ba BB BB Lower Medium Grade
B B Grade
(Speculative)
Caa
Ca
C
C
CCC
CC
C
D
CCC
CC
C
D
Poor Quality
Most Speculative
No interest being paid or bankruptcy petition filed
In Default
Source: Bond Market Association.
* The ratings from Aa to Ca by Moody’s may be modified by the addition of a
1, 2 or 3 to show relative standing within the category.
** The ratings from AA to CC by Standard & Poor’s, Fitch IBCA may be modified by the addition of a plus or minus to show relative standing within the category.
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