New Ways to Think About Credit Ratings
- 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.
* Source: Moody’s Investors Service Special Comment: “U.S. Municipal Bond Defaults and Recoveries, 1970-2011,” March 7, 2012
Fixed-income investing entails credit risks and interest rate risks. 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.
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