Municipal bond investors generally consider a bond’s high credit rating a positive feature. But are there times when a low credit rating can offer investment opportunity? We believe there may be. Recognizing opportunity, we have found, requires a deeper understanding of the credit rating business than most investors have.
Most bond investors know that Nationally Recognized Statistical Rating Organizations (NRSROs) – the “credit rating agencies” – differentiate between bonds with varying risks of default by issuing ratings expressed in the form of “AAA,” “BBB” and the like. But a bond’s letter rating doesn’t tell its whole credit story, and the institutional rating of municipal bond credit could be perceived to include a downward bias.
Comparing the default history of A-rated municipal bonds to A-rated corporate bonds offers a dramatic example. The trailing, 10-year cumulative default rate for A-rated General Obligation municipal bonds was 0.05%, according to Moody’s Investors Service, which looked at the entire universe of municipal bonds it rated from 1970 to 2013; for corporate bonds with a Moody’s A rating during the same period, the default rate was 2.73%. Stated differently, A-rated corporate bonds experienced a default rate over 50 times greater than the default rate for A-rated General Obligation bonds during the period.
One dynamic of the credit-rating business is that ratings best not be overly optimistic. Low-rated bonds that never default do not invite questions from investors; but even one, occasional highly-rated bond that does default can set off a barrage of inquiries into rating methodology.
This same dynamic can lead to illogical results. In recent years, for example, we have seen a variety of unusual decisions by the NRSROs:
- A downgrade of U.S. Treasuries, even though the borrower can print more money to pay debt service.
- The creation of a global rating scale in an effort to “true up” corporate debt ratings with municipal debt ratings, resulting in wide-scale upgrades of municipal bonds.
- Downgrades of Puerto Rico municipal bonds, including bonds financing the Puerto Rico Aqueduct and Sewer Authority (PRASA) immediately after PRASA was granted authority to increase water rates by 67%.
- A downgrade of “tobacco bonds” based on fears of tobacco consumption decline but no subsequent upgrade when the anticipated decline failed to materialize.
Until recently, a rating agency’s opinion was considered by many investors the “gold standard” in determining the creditworthiness of a particular municipal bond issuer or its bonds. Some investors have even taken the view that a bond not rated by one or more of the three largest rating agencies carries too much risk to invest in at all. We, of course, disagree with that view. An NRSRO’s rating (or opinion) about a specific bond is similar to a consumer credit bureau’s assessment of an individual’s credit profile, except that the rating agencies opine on creditworthiness of governments, corporations and other entities. In all cases, creditworthiness is ultimately measured against a similar standard: namely, the likelihood that a borrower will repay a loan in full, with interest and according to the terms of the loan.
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Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates, or an expectation of rising interest rates in the near future, will cause the values of a Fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at, or near, historic lows. When interest rates rise, bond prices fall and a fund’s share price can fall. Municipal bonds are subject to default on income and principal payments. Further, a portion of some funds’ distributions may be taxable and may increase alternative minimum tax (AMT) for investors subject to that tax; distributions from net realized capital gains are taxable as capital gains. The funds invest in below-investment-grade debt securities, which may entail greater credit risks, as described in each fund’s prospectus. These securities (sometimes called “junk bonds”) may be subject to greater price fluctuations and risks of loss of income and principal than investment-grade municipal securities. The funds may invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. The funds may also invest substantially in Puerto Rico and other U.S. territories, commonwealths and possessions, and could be exposed to their local political and economic conditions.
Deterioration of the Puerto Rican economy could have an adverse impact on Puerto Rican bonds and the performance of the Rochester municipal funds that hold them.