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Opinions Mixed on Recalibrations

The jury is still out among investors on how the municipal bond market will respond during the transition phase of the recalibration of tens of thousands of muni credits to a global rating scale by Fitch Ratings and Moody’s Investors Service.

Fitch on Monday began lifting its ratings on more than 38,000 municipal bond issues under a systematic overhaul of the way it grades the credit quality of state and local governments.

Moody’s, meanwhile, plans to roll out a similar recalibration beginning April 19, and over four weeks will eventually replace all of its 70,000 “sale-level” ratings on the outstanding municipal bonds of 18,000 issuers. The recalibrations — which they say will put munis on the same level with corporate and sovereign debt — will be implemented in stages, with changes generally occurring for all ratings within a given sector on the same day, according to Moody’s.

Standard & Poor’s has long maintained that it already uses a uniform scale across all major credit sectors.

Tom Spalding, senior vice president at Nuveen Advisory Corp. in Chicago, is among those that believe rating ­municipals on a global scale will boost demand for muni debt, since there will be more higher-rated bonds available, but will have little impact on trading values in the near term.

He said the bonds targeted for ­recalibration by Fitch and Moody’s are worthy, but Nuveen will continue to place heavy emphasis on its own internal rating process.

“I don’t see a lot of risk in what Fitch is doing, and for Moody’s, I think it’s going to be a wait-and-see situation,” said Spalding, who manages 11 national uninsured municipal funds with $10 billion in assets.

He also believes the transformation is long overdue because municipals have had historically lower default risk than corporate bonds.

Michael Decker, managing director and co-head of municipal securities at the Securities Industry and Financial Markets Association in Washington, D.C., said the recalibration has drawn a line in the sand among municipal investors.

“Some market players feel that there is only a change in the rating label associated with the bonds and no change in the underlying fundamentals of the credit, so those bonds are not likely to be repriced significantly,” Decker said. “Others believe demand for some bonds that are rated into higher categories will increase because they will become eligible investments for a larger number of investors, and the re-rating will cause a repricing.”

“Some investors tend to allocate their portfolios among certain rating categories in terms of their own internal policy,” Decker said, or, as with money market funds, by regulatory legislation, such as Rule 2a-7, which limits the debt the funds can own based on maturity, liquidity, and credit quality.

“If bonds are recalibrated into higher categories, there will be a larger universe of money market funds to invest in those bonds,” he said.

But not everyone supports the changes.

Pam Tynan, manager of the tax-exempt money market desk at Vanguard in Valley Forge, Pa., said even though the recalibration is positive from a supply standpoint, she believes it is negative in principle.

“We have heard the rationale about why it should be implemented, but there are a lot of people that don’t buy into that methodology and we are one of them,” she said. “We believe the current methodology is appropriate.”

The move to a global rating scale will prompt the inflation of ratings on municipal issuers in the absence of a credit event, according to Tynan.

“This is occurring at the very time that the regulators have adopted amendments to Rule 2a-7 that require greater liquidity, higher overall credit quality, and greater transparency for investors,” she said. “The rating changes will mitigate some of the benefits the changes to the rule were intended to address.”

Chiefly, she said, “the move to a global rating scale will reduce those municipal issuers that would have warranted a second-tier rating.”

In addition, Tynan believes the recalibration will strip value currently available to investors discerning differences between different levels of municipal credits. “By pushing up all the ratings, that does not create that differentiation that we believe is valuable to the process and investors,” she said.

“For institutional investors, it will be harder to extract that value as a result of the pricing changes and how fast they will be implementing this pretty aggressive roll-out,” Tynan said.

By comparison, Clark Wagner, director of fixed income at First Investors Management in New York City, who manages $1.5 billion in municipal bond mutual funds, said retail investors will get a big confidence boost from the move to a global scale.

“I think inevitably it tends to have a positive impact on the market when people see a double-A rated that used to be single-A — especially among retail,” he said. “Retail cares more about ratings on a security because they don’t do their own research and if they are willing to pay more, then over time the whole market will adjust.”

The recalibration will make less difference to institutional investors that do their own research, he said.

“I don’t think there’s going to be a huge difference, but over time it will help quality spreads tighten,” Wagner said. “It will be interesting to see if investors discriminate between categories more than they used to.”

Lyle Fitterer, managing director of the tax-exempt group at Wells Capital Management in Milwaukee who manages funds and separate accounts that total $23 billion, said the effects could eventually draw demand away from the high-quality market.

“To the extent the spreads tighten in the rated stuff because of the upgrades, people are going to look to markets that have more high yield,” he said.

Overall, he believes the most important factor is how buy-side firms will adjust their internal ratings to reflect the changes being made by Moody’s and Fitch.

Wagner agreed. “You have to adjust to the realities of where the market is trading the securities, but I haven’t seen anything to indicate tightening yet,” he said.

One of the perks of the recalibration will be felt by Build America Bond investors, he said.

“A global ratings scale allows investors to compare apple to apples when they are comparing BABs to corporates,” and will be especially useful for foreign buyers who are unfamiliar with the U.S. municipal bond market, Wagner said.

Decker agreed, saying, “The ­recalibration makes it easier to compare their ratings on their municipal portfolios with the ratings on their corporate portfolios.”

Overall, he said the actual effects of the recalibration still remain to be seen. “Some investors like the current practice of having municipals on a separate scale because it results in greater stratification of ratings” and avoids overcrowding of bonds into one category or another, Decker said.

“This is one of the many things from a technical and fundamental perspective that is happening in the municipal market that should be a positive overall,” Fitterer said. “It will impact certain credits more than others, but how big of a positive it will be, we’re not sure.”

“Whether it’s the right thing or the wrong thing, it’s a decision the market has known has been coming for a long time,” Decker added.

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