In the third quarter of this year, two major ratings agencies issued more downgrades to cities than upgrades on public debt. Meanwhile, the third major agency issued more upgrades than downgrades. And instead of those actions balancing each other by meeting in the middle, sometimes the range between ratings increases.
“I’m sure it’s confusing [to issuers] and it’s confusing to investors also,” says Natalie Cohen, managing director of Wells Fargo Securities. “What can happen in some cases is you can have an upgrade and a downgrade on the same bond offering.”
Credit ratings are assigned to a municipality's bonds and are meant to grade how likely it is that investors will be repaid on those bonds. Bonds range from AAA (the gold standard) to D (default) and anything rated lower than a BBB- are considered junk bonds. Depending on the fiscal health of a municipality or district, ratings agencies can reassess their initial bond rating and upgrade or downgrade.
The actions by Standard & Poor’s (which is mostly upgrading), Moody’s and Fitch (mostly downgrades) are a result of agencies revamping their criteria in the wake of the financial crisis. The agencies are not necessarily supposed to align – they have different methodologies for rating debt, and they cover different types of issuers. Still, the conflicting tones are a good reminder for investors (and issuers) that a credit rating these days is all about context.
After all, says Matt Fabian, managing director at Municipal Market Advisors, it’s good to remember that credit ratings are paid for by the issuers themselves who want a credit rating for their bond sale. (Very small offerings, however, are not rated.) “People over expect what a rating is,” Fabian says. “If you admit ratings are a more of a tool to distribute bonds, then all the problems with ratings go away.”
The agencies, for their part, have been consistent: Moody’s has not had more upgrades than downgrades in two years. Meanwhile, in just one month in the last two years has S&P issued more downgrades than upgrades, according to Fabian’s analysis. All three agencies said following the third quarter close that their patterns are likely to continue.
So what does all that mean for today’s issuers? Cohen says it helps to remember credit ratings are only part of the picture in today’s market. Many investors do their own analysis and don’t solely rely on a credit rating to determine whether a bond is investment grade in their view. “It’s not entirely clear that the market trades on the ratings,” she said, noting Puerto Rico has been treated by the market as junk bonds “for quite a long time but it is still rated as investment grade.”
Issuers are also selling to a different kind of buyer than they were a year ago. In his weekly brief tailored to issuers, Fabian notes that the market volatility this summer led to the first decrease in municipal fund ownership since early 2011. Individual (retail) investors are letting their bonds be called and buying fewer new bonds directly. Meanwhile, banks are increasing their share. In short, this means that buyers are becoming more sophisticated as they have greater research capabilities and hedge fund managers especially are not necessarily turned away by a lower credit rating.
“As long as the bond is investment grade,” Fabian says, “other factors – particularly [issuer] liquidity – have become more important than the rating.”