Moody’s Investors Service said it will change the way it rates state and local bonds to bring it in line with the way it assesses comparable corporate securities.
The move represents a bow to political pressure, whose proponents argue that municipalities, which historically have had exceptionally low default rates, have been penalized by the dual ratings system and paid higher borrowing costs as a result.
Moody’s announcement comes just days after a similar proposal was included in a financial overhaul bill proposed by Sen. Christopher Dodd.
About 70,000 ratings will be subject to the changes. The largest impact is expected to be felt by local governments, who can expect their existing and future general obligation issues to rise one to three rating notches. The rating changes, beginning in April 2010, will take place over a four-week period and bring parity to all Moody’s ratings.
Moody’s has used its current scale to assess the risk of municipal bonds since 1918.
Strong criticism has been leveled at all three rating agencies for rating sub-prime and related financial-engineered securities at higher levels than traditional municipal credits. Standard & Poor’s has repeatedly stood by its existing rating scale, and maintains that its municipal ratings are already in line with other issuer types.
The changes will result in an upward shift of a large number of municipal ratings. Moody’s states however that, “market participants should not view the recalibration…as rating upgrades, but rather as a recalibration of the ratings to a different rating scale.”
Moody’s emphasized that these changes are an effort to make municipal and non-municipal ratings more comparable, especially to a growing number of investors who are active in both the tax exempt and taxable markets. By repositioning its municipal scale, Moody’s is attempting to make its ratings “predictive of both relative and absolute” credit risk. Consistency across sectors should reflect approximately equal average levels of default over extended time periods.
Moody’s approach involves a three-step process. In the first step, it benchmarks credit risk for a representative sample of issuers in each municipal sector against non-municipal credits already rated on the existing “global scale.” These municipal issuers then serve as a reference against which other issuers within the same sector will be evaluated.
The second step utilizes the rating benchmarks from step one to establish consistency among ratings across each sector. For example, tax-exempt healthcare ratings were examined as a group to ensure compatibility with taxable healthcare ratings and their treatment on the global rating scale.
The final step will apply the revised rating approaches to individual credits within each sector.
In its announcement, Moody’s indicated that not all municipal sectors will require the same level of rating re-adjustment. The greatest change is expected to occur for state and local government general obligation ratings, which are likely to move up approximately two notches, and possibly as many as three. Higher rated credits of “Aa3” or above will increase less than those farther down the investment grade scale. Investment grade issuers in the “A” and “Baa” categories will likely see the largest rating increase. State and local debt secured by specific revenues, such as sales taxes, are viewed as more volatile than GOs, and are likely to move up less.
Municipal revenue bonds will change little, if at all, since they are already calibrated to the agency’s global scale. Included in this category are bonds issued for housing, healthcare and other “enterprise” sectors.
Insured bonds will be treated as follows: The new rating will reflect the financial guarantor’s financial strength rating or the issuer’s underlying rating, whichever is higher.
The upward shift of municipal ratings, mostly in the state and local government sector, acknowledges Moody’s view that historically, the default rate for municipal issuers has been extremely low. “Unlike corporate issuers, most municipal issuers have the ability to raise fees or taxes,” Moody’s said. Municipal revenue bond issuers, while not taxing entities, often have dominant market positions or monopolies in their service areas, such as in water and sewer systems or major hospitals.
Although the economy has been mired in a deep slump, and state and local budgets have been stressed, Moody’s foresees few if any defaults. While the critical decisions necessary to restore balance will be subject to a messy and difficult political process, state and local governments are accustomed to the give and take required to reach budgetary compromise.