Some municipal bonds have rallied significantly since Moody’s Investors Service and Fitch Ratings last month overhauled their systems for assigning ratings to state and local government credits — effectively upgrading almost the entire universe of muni bonds.
The effect is most noticeable for California and Puerto Rico, which enjoyed three-notch improvements in their ratings and made the symbolic leap from ratings beginning with the letter “B” to those beginning with an “A.”
For many credits that jumped only a notch or two and were perhaps already well-regarded by the market, the ratings boost has had little to no impact on the way the bonds perform in the market.
In early March, Moody’s and Fitch acknowledged their systems imposed ratings on municipalities that were too strict compared with ratings on sovereign governments, corporate bonds, and structured vehicles such as mortgage-backed securities.
Municipalities that issue rated bonds have historically exhibited minuscule default rates, yet were often rated lower than their corporate counterparts.
Moody’s and Fitch raised the ratings on tens of thousands of bonds.
In divining what the effect on the market would be, municipal market watchers split into two general camps: people who thought the market would disregard the new ratings and continue imposing their own spreads on bonds with weaker credit, and people who thought the market would eventually honor the new ratings and the bonds would trade accordingly.
Early on, it appears the latter camp was correct.
Formerly rated Baa1 by Moody’s, California was lifted to A1 last month.
Based on the Municipal Market Data scale, California’s debt has traded up significantly since then.
The spread of the yield on a 10-year California general obligation bond over the triple-A yield has shrunk about 40 basis points since Moody’s first announced its recalibration in mid-March.
Moody’s rating on Puerto Rico went from Baa3 to A3.
The spread on Puerto Rico’s 10-year bonds over triple-A municipals has shrunk 42 basis points.
“ 'Higher’ ratings, via ratings recalibration, have indeed contributed to credit-spread tightening, in some cases quite drastically,” Morgan Stanley Smith Barney senior fixed-income strategist John Dillon wrote in a report this week.
The reason higher ratings without any attendant improvement in credit quality have propelled bond prices is that they expand the potential buyer base, according to Dillon.
Many institutional investors face restrictions on what they can buy — for example, nothing rated below single-A.
“Newly minted single-A paper now fits into more conservative investment policies, and funds and many individual investors find significant comfort in owning single-A rated securities over Baa/BBB rated bonds,” Dillon wrote.
This may help explain why some states that now command higher ratings have seen minimal improvements in yields.
Under the Moody’s recalibration, five states not previously rated Aaa now are.
Indiana and Tennessee each have tightened less than five basis points. Iowa, Texas, and New Mexico have seen essentially no change.
“For the most part it’s been minimal,” said Daniel Solender, director of municipal bond management at Lord Abbett & Co.
Except California and Puerto Rico, Solender said most credits have improved by perhaps a few basis points at most.
Assessing the effect of the recalibrations on the municipal market is beset by measurement problems.
Most municipal bonds do not trade on any given day. Sometimes a spread has more to do with the benchmark than with the bond itself. Spreads can bounce around without any fundamental cause.
Puerto Rico’s spread over the triple-A scale has been narrowing practically without interruption for a year as the government there has cut spending and raised taxes.
California’s spread has lurched up and down since early last year.
The proposition that the latest spread-tightening is attributable to the recalibration, or is even out of the ordinary, is unprovable.
Then of course there is the confounding matter of measuring bonds against the triple-A scale when the mix of bonds that compose the triple-A scale itself has changed.
Ashton Goodfield, head of municipal trading at DWS Investments, said some of California’s spread-tightening is attributable to the recalibration, while some is not.
“There’s so much going on in the marketplace right now with spreads widening and narrowing that it’s hard to take out the noise and find out what’s really impacting levels,” Goodfield said. “We have observed a few changes that we feel are at least partly due to the recalibration. ... There are a few factors causing the tightening.”
Goodfield said the credits that stand to benefit the most are the ones that bound into a new category, like California and Puerto Rico jumping out of the “B” group.
Another example is San Antonio, Goodfield said. The Texas city was previously rated AAA by Standard & Poor’s, AA-plus by Fitch, and Aa1 by Moody’s.
After the recalibration, the city is now triple-A across the board. That bumps the credit into the top-notch category, Goodfield said, as opposed to the split ratings it used to have.
Goodfield said she has seen some improvement in the trading of San Antonio’s bonds.