A Facelift for Muni Bonds
Surprise! Your bond ratings just went up!
Here's the financial paradox of the year: Just as they face the worst financial mess in decades, with endless reports of more layoffs and furloughs, many state and local governments will be assigned higher-letter bond ratings under a "global recalibration" in the credit-rating industry. Investors will see a host of new AAA/Aaa and AA/Aa muni bonds in the market, even though financial conditions have worsened in 2010 and reserves have been exhausted.
On April 16, Moody's Investors Service will join other credit rating agencies in "recalibrating" the nation's municipal bonds on a global rating scale. The global scale treats all issuers alike: private companies, sovereign governments, nonprofits and municipalities. For many general obligation (G.O) muni bonds backed by the full faith and credit of the taxpayers, that will mean a ratings upgrade of one to three notches on the rating scale. (Notches are pluses and minuses, not letters.) Fitch Ratings has also begun to recalibrate its credit ratings; Standard & Poor's had already adopted a global approach.
The recalibration does not reflect an actual improvement in public-sector credit quality in 2010. (Moody's emphasizes that this is not a mass "upgrade.") It's simply an effort to apply the same ratings criteria to governments as those applicable in the private sector. Moody's explains that they have taken into account decades of historical data showing that tax-backed debt of U.S. states and localities has rarely defaulted and resulted in losses to investors. This "probability of recovery" approach is a subtle shift from the traditional emphasis on "timely payment of principal and interest," but it captures the key difference between public and private sector debts. With public debt, the taxpayers are usually on the hook to pay up, eventually. Lehman Brothers and Bear Stearns may evaporate from the face of the planet, but California and Chicago will not.
Revenue bonds issued by public enterprises, utilities, airports or conduit financing agencies may or may not enjoy a similar step-up in ratings, since they lack a taxpayer backstop -- a key factor in Moody's philosophy of global ratings conversion. So this shift is hardly universal throughout the muni market.
State treasurers and other professional associations have argued for years that the ratings agencies applied a dual standard that treated municipal bonds unfairly in comparison with private corporations. They cited the low historical default rates on munis as a prime example of inequitable treatment. So now, they have got their wish, and for some it probably couldn't come at a better time, as many states and localities are scrambling for money in the credit markets just to make ends meet. In California, the ratings recalibration could play an important role in retail-investor attitudes.
Although the idealistic and academic theory of recalibration is that ratings quality and credit risk is already factored into the market and these new standards are just cosmetic, the actual impact will be broader than that. Some municipal bond funds invest only in AAA-rated paper, for example. This recalibration will immediately make a host of higher-yielding paper eligible for purchase by these portfolio managers. Some would argue that it will result in a marginal reduction in real-word credit quality for the ultimate investors. Now, the skeptics argue, any "Tom-Dick-and-Harry" municipal G.O. bond can become an AAA or AA credit. This "grade inflation," some investors feel, waters down their carefully selected high-grade portfolios.
While we're reflecting on the paradox of higher ratings at the nadir of the public sector's fiscal well-being, here's another twist that the ratings agencies have essentially ignored in this paradigm-shift: Underfunded public-sector retirement liabilities. Show me a corporation with an AAA or AA bond rating that has unfunded pensions and retiree medical benefits anywhere near the level of comparably rated state and local governments. You can't. They have already been downgraded for their abominable balance sheets, or they converted their pension plans to 401(k)s and eliminated retiree medical promises. Yet most muni bond issuers -- and the ratings agencies -- continue to keep their heads in the sand when it comes to recognizing and addressing the avalanche of governmental retirement payouts and cost increases coming due very soon.
Of course, if the Moody's approach to "likelihood of recovery" remains the key credit standard, one could argue that muni bondholders won't suffer from these overhanging retirement deficits. Instead, we could just see layoffs, service reductions, hiring freezes and higher taxes to pay those impending retirement bills. Cities subject to tax caps will just have to shrink their workforce to balance their budgets. I can't help but wonder whether a municipal bankruptcy court would put bondholders ahead of pensioners -- or the public safety of local taxpayers who demand a minimal level of public services.
Moral: Those who become AAA overnight may not keep it for long if they fail to act like AAA credits in the corporate world.