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New Ways to Think About Credit Ratings

Highlights

  • The letter rating assigned by NRSROs only tells part of a municipal bond’s credit story
  • Despite historically low default rates, ratings tend to become pessimistic over time
  • Because NRSROs use formulaic methods, positive features of a bond may get overlooked
  • This phenomenon has the potential to create investing opportunities

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, as we explain in part one of a two-part series.
Investors should note that:

  • Moody’s Investors Service, in its periodic review of the entire universe of municipal bonds that it has rated since 1970, has repeatedly confirmed that the trailing, 10-year cumulative default rate for A-rated municipal bonds has been significantly less than the same measure for A-rated corporate bonds.  In the latest Moody’s report, the rate was 0.04% for munis versus 2.22% for corporate bonds.*
  • One dynamic of the credit rating business is that ratings best not be overly optimistic. But this had led to illogical results and some rather unusual rating agency decisions in recent years.
  • Creditworthiness is a measure of the likelihood that a borrower will repay a loan in full, with interest and according to the terms of the loan—regardless of whether the loan (or bond) has been rated by one or more of the NRSROs.

The history of how today’s credit rating agencies have evolved provides some important context, we believe, for investors who are considering the purchase of a municipal bond that, right or wrong, has been labeled “unworthy” by the rating agencies. 

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* Source: Moody’s Investors Service Special Comment: “U.S. Municipal Bond Defaults and Recoveries, 1970-2011,” March 7, 2012

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