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A New Crimp in Curve Calculations

Anyone studying the path of yields on double-A or triple-A rated municipal bonds over time might want to put a little asterisk next to April 2010.

Beginning this month, Moody’s Investors Service and Fitch Ratings are implementing systematic overhauls of the way they assign ratings to many kinds of state and local government debt.

While they avoid using the word “upgrade,” these “recalibrations” have already promoted tens of thousands of bonds into higher ratings categories.

No matter how the market responds to these recalibrations, they pose a measurement problem to the companies that maintain yield curve scales and indexes.

Yield curve scale services like Municipal Market Data and Municipal Market Advisors offer their opinions of what yields are for given maturities at given ratings levels.

One way or the other, the recalibrations will distort the very meaning of a yield at a given ­rating.

If investors and traders treat newly minted triple-As that got to that level because of recalibration differently from bonds already rated triple-A, then the triple-A category will have a wide range of yields.

If investors treat all triple-A bonds the same regardless of provenance, then the supply of top-rated debt will be greater and yields overall would be higher.

Either way, it will be more difficult to compare yields and spreads over time.

Robert Nelson, who oversees Thomson Reuters’ MMD scale, said he will have to wait to see how the market reacts before adjusting the scales.

“It’s going to take some time for the market to really kind of get its arms around what that means and where these credits land after recalibration,” he said.

Nelson expects recalibrated credits to trade at a spread to holdover bonds in their respective categories.

That means the scales will probably have to be read with a chronological “line in the sand” after the recalibrations, he said, recognizing a shift in the definition of what exactly a double-A or triple-A bond is.

Because bonds within given ratings levels will trade at a wider variety of yields, the mid-level yield offered by the yield curve might warrant a different interpretation, Nelson said.

MMD tries to show the strongest prices for triple-A rated municipals, and “middle of the road” prices for everything else, he said.

Austin Tobin, who maintains yield curves at Delphis Hanover, also plans to wait to see how the market responds.

It does not make any sense to adjust the scales now without seeing how investors and traders treat recalibrated ratings, he said.

Tobin expects the market to make its own distinctions about municipal credits, meaning recalibrated bonds will trade at a discernible spread to the bonds already populating top categories.

The challenge of adjusting a yield curve to these recalibrations raises an interesting question about how investors perceive municipal bonds — does a double-A rated municipal trade at a spread to a triple-A because the double-A has weaker credit quality, or because it has a lower rating?

In other words, if a double-A municipal bond is recalibrated to triple-A with no attendant improvement in fundamental credit quality, will investors pay the same price for it, or more? And how much more?

According to Matt Fabian, managing director at Municipal Market Advisors, investors at first will try to ferret out the weaker credits within the top categories and impose a spread over the highest-quality bonds.

That will not last, he said.

Eventually, the prices of the bonds will converge to the ratings, he said.

Fabian, whose company maintains a set of municipal yield curves based on institutional bids, said pricing in state and local government debt is more about segmented demand than relative credit quality.

Credit spreads among investment-grade municipals spring not so much from credit risk as from the practicality of eliminating buyers as you go down the ratings scale, Fabian said.

By raising the ratings on these bonds, he continued, the rating agencies put them in play for more investors. That — and not marginal credit inferiority — will be what drives the yields on these bonds.

“The benefit for the issuers being upgraded or having their ratings increased, they will have access to a larger universe of buyers,” Fabian said.

It is true that investors prefer higher-quality bonds, he said, but the ratings never did a good job of predicting defaults anyway.

To illustrate: the average 10-year default from 1970 to 2009 for general obligation credits rated double-A by Moody’s was higher than the default rate on credits rated single-B.

The investment-grade default rate was the same as the speculative-grade default rate.

Fabian said the likely outcome of the recalibrations will be a flood of new supply in the higher ratings, pushing up yields.

“It’s going to tend to make our curve and all other curves a bit cheaper,” he said.

The supply-driven updrift in yields will not be so severe as to break comparability completely, Fabian said, but the scales will probably need a footnote showing when the recalibrations were implemented.

In his latest weekly market report, Morgan Stanley Smith Barney municipal strategist George Friedlander echoed Fabian’s belief that the market’s distinctions on recalibrated bonds will be temporal.

Friedlander said the bump in yields owing to new supply in the top-rated categories is likely to be “extremely modest” — perhaps five basis points.

The Bond Buyer’s indexes will be calculated the same way with the same bonds, though the Moody’s average rating equivalent may go up because of the recalibration.

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