Insurance does not make a bad bond good, though an investor could be forgiven for thinking that it does. For years investors in insured bonds have looked to the higher rating, based on insurance, rather than the underlying rating, when there was one.
No longer, Fitch Ratings said on Monday. The agency is withdrawing its ratings from all insured bonds for which it does not have an underlying assessment.
The decision is a reaction to volatility in the insurer financial strength ratings Fitch assigns to bond insurers over the past couple of years, said Karl Pfeil, a managing director at Fitch.
“The IFS ratings that we have are no longer triple-A, and at the current rating level there are probably issuers that may have underlying ratings that are above that, and if we don’t have the underlying rating we feel it would not properly reflect the true credit quality,” he said.
Matt Fabian, managing director at Municipal Market Advisors, characterized the move as part of an evolution in the bond insurance industry.
“Typically, bond insurance works as a credit substitution, where the bond insurer’s rating is taken instead of the issuer,” Fabian said. “But the market has evolved in how it uses bond insurance to be more of a joint default, where they look at the implied probability of both defaulting at the same time.”
In cases where Fitch has no underlying rating to provide, the insured rating will be withdrawn. This move leaves a huge number of bonds — 147,584 Cusips from more than 8,500 issuers — with no rating at all, at least from Fitch. The vast majority of these bonds were insured by Financial Security Assurance Inc., while a smaller percentage were backed by Assured Guaranty Ltd.
Where these bonds have ratings from Standard & Poor’s or Moody’s Investors Service, the market impact may be small. But for securities that were rated solely by Fitch, they will turn from having high ratings to none at all.
“If you’re a retail investor, it becomes a high-yield bond,” Fabian said. “I’ve had bonds that were backed by the federal government and had to be treated as if they were high yield just because they were unrated.”
That, in turn, could cause the securities’ liquidity to dry up. Some investors work under guidelines to only purchase securities if they have two ratings, so the loss of a rating from Fitch could exclude that bond from a certain class of investors. Fewer buyers means less liquidity, Fabian said, and that could hurt sentiment amongst holders in the secondary market.
Fitch’s decision will not affect insured bonds that have underlying ratings from the agency, tender-option bond structures, insured floater bonds where Fitch was requested to rate the structure and the structured long-term rating is based on the insured rating.
Fitch also said a small number of bond issues that were explicitly requested to be rated only on the insurer’s rating will not be affected.
Fitch last year had withdrawn its ratings of all bonds insured by the then-XL Capital Assurance, now Syncora Guarantee Inc., that did not have underlying Fitch ratings.