Moody’s Investors Service is seeking commentary as it considers updating its rating methodology for municipal debt that is backed by letters of credit.

In its current strategy for analyzing debt enhanced with LOCs, Moody’s takes into account the long-term rating of the borrower and the bank providing the LOC, the amount of LOC support, and the default dependence between the obligor and the bank.

“The recent economic cycle has demonstrated the increased interconnectedness between the banking sector and obligors in the U.S. municipal market, particularly those obligors with variable-rate debt,” according to the Moody’s proposal. “As a result, we are proposing an enhanced analytical framework to assess the default dependence between these obligors and LOC banks.”

Moody’s anticipates that if it adopts an enhanced review of credit connections between issuers and LOC providers, the change would lower by zero to three notches the long-term ratings on existing transactions. About 70% of existing LOC-backed debt that Moody’s rates would drop within one notch and 90% would fall by within two notches, according to the report. Rating outcomes for new transactions would be zero to two notches above the LOC bank’s long-term credit rating.

“Short-term ratings will not be affected by the transition to the updated ­methodology,” the report said.

Proposed changes in rating methodology include examining the extent to which borrowers and LOC providers generate their revenues from the same geographic area, market base, or sources. Moody’s would also assess a borrower’s level of bank-supported variable-rate debt as enhanced floating-rate transactions can involve risks such as credit enhancement expirations, rating triggers, and other issues.

“Obligors with high levels of bank-supported variable-rate debt are exposed to both the specific banks that provide credit and/or liquidity support on their variable-rate debt, as well as to banking industry changes or stresses,” Moody’s said. “Banking industry changes or stresses can result in increased debt-service costs on variable-rate debt and higher costs on or difficulty in obtaining credit and/or liquidity facilities.”

Moody’s views issuers with more than 50% of bank-supported floating-rate debt as having high financial-operational linkages with the banking sector. Obligors with less than 20% of such debt would be considered as having “a low linkage.”

“Fundamentally, LOC-backed debt is of the credit quality of the credit provider,” said Guy Lebas, chief fixed-income strategist at Janney Montgomery Scott. “And with all that has occurred in the financial system and with government support sort of stepping back, the rating agencies’ ­perception of financials is changing a great deal.”

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.