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No Change in Risk?

The migration upward as a result of a switch to global rating scales might not lead immediately to homogenized prices for similarly rated municipal bonds, market participants say.

"My bottom line is that risk hasn't changed, no matter what you call it," said Guy LeBas, fixed-income strategist at Janney Montgomery Scott LLC. "The risk of a given issuer isn't changed just because a rating agency has a different scale. If the markets are rational, then risk should be priced the same."

LeBas said retail investors, who tend to be more "emotional," might view a credit as more attractive when it was upgraded, but that would only lead to "marginal differences" in pricing.

"On the surface of things, from a purely rational perspective, nothing has changed," LeBas said.

Issuers have clamored for global rating scales, saying their costs of funds have been higher because their debt is rated systemically lower than corporate borrowers with similar rates of default. Prodded by strident criticism from public officials, such as California Treasurer Bill Lockyer, congressional hearings and legislation, and a lawsuit from Connecticut Attorney General Richard Blumenthal, the agencies have taken steps to address these concerns.

Moody's Investors Service has said it is gathering public comment on its own move to a global rating scale. At the end of July, Fitch Ratings released an exposure draft of its proposed municipal rating framework and will solicit comments until Aug. 29. Standard & Poor's maintains that it has always had a global rating scale, but said it recently "re-benchmarked" public finance credits as a result of default studies.

As a result of these changes, public finance credits will likely see mass upgrades even in the face of a weakening economy. In line with its re-benchmarking, for instance, Standard & Poor's upgraded 604 credits in the second quarter, compared to its average of 87 upgrades per quarter since 1986.

"A weakening economy will not necessarily lead to a change in rating performance," said Standard & Poor's analyst James Wiemken. "If you look at tax-backed ratings, for example, through several recessions going back to 1996, upgrades have consistently exceeded downgrades, and that's actually part of the reasons for our upgrades. We believe that the fund balances and policies state and local governments have put in place have positioned them well to weather this current economic downturn."

Fitch expects the changes to its framework will result in 86% of state and local general obligation credits being rated in the AA or AAA categories, compared to 58% under its current system. Just 10.1% of corporate finance ratings fall within that range, Fitch said.

But at least one issuer still isn't happy. Lockyer's office expressed dismay that the state's credit rating would only move to AA-minus from A-plus under Fitch's proposed scale. That one notch revision is in line with the revisions on other A-plus-rated general obligation and senior revenue bonds, because Fitch will make most rating changes systemically under the recalibration.

"It's really totally inadequate," said Lockyer spokesman Tom Dresslar. "It does nothing to address the problem, which is that ratings are not based on risk of default. It's woefully deficient in terms of bringing fairness of taxpayers. ... We've never defaulted, we won't ever default, and we get a one-notch upgrade."

At the National Association of State Treasurers annual conference this week, Lockyer - who has led the charge against rating agencies - will introduce a resolution for the group to support legislation proposed by Rep. Barney Frank, D-Mass., that would require rating agencies to use a single scale for municipal and corporate debt based only on the likelihood of repayment.

Fitch's report said its ratings do not correspond to specific default frequencies, but rather aim to be a relative measure of creditworthiness between issues. This task becomes especially difficult across asset classes, Fitch noted, because municipal and corporate debt does not face the same types of risk. In addition, as the collapse of residential mortgage-backed securities showed, historical performances do not necessarily provide a good indication of the future.

"Harmonizing ratings across different asset classes is a challenging exercise," Fitch said.

Another issue Fitch sought to address was rating granularity. With such a large number of credits in the top two classes, the rating agency said it wanted to take into account the market's desire to still have some way to differentiate between municipal debts.

"Any system that works for issuers has to work for investors," said Alan Anders, deputy director of finance for New York City's office of budget management and member of the Government Finance Officers Association's debt committee. He said the step toward global scales is "positive," stressing he was speaking for himself and not the GFOA or New York City.

Current credit-default swap spreads on municipal debt show that the market does differentiate between similarly rated bonds, according to Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management.

However, Ciccarone said he worries that unless a major default occurs within the next few years, the market will become "complacent" and view all triple-A ratings as representing the same quality of debt. He noted that in the past, insured paper traded at spreads based on which company backed it, but eventually the market narrowed to a uniform price.

Prior to the Great Depression, most state and cities were rated double- or triple-A because no one thought they would default, he said. Of defaulting issues, 78% had been rated double-A or better in 1929, according to a study he referenced by George Hempel.

The three rating agencies need to consider all the historic data available and remember that the economic downturn, pension liabilities, other retirement benefits, and infrastructure costs will weigh on municipal issuers in the future, he said.

"The market is still going to differentiate out of the box ... but I'm skeptical over time, that if there's no string of defaults, there will be another let down of the guard," Ciccarone said.

Institutional investors likely have research capabilities to evaluate credits, which means upgrades won't lead to "drastic change" in demand or interest rates, Anders said. However, he and market participants agreed it's unclear how retail and foreign investors might respond to uniformly higher ratings in the long term.

"I think the upgrades will ultimately help lower the cost of funds, which is what the authorities are trying to accomplish, but I think it will take some time," said Matthew Dalton, chief executive officer of Belle Haven Investments. "It's not going to happen overnight. The market will accept whatever the end-user makes them accept. If ma-and-pa retail will buy the bond because it's triple-A instead of double-A, the market is going to accept it."

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