Underrated.
How else to explain how regulators and credit agencies regard municipal bonds?
Take, for example, a recent report on two interesting studies by Moody’s Investors Service and Standard & Poor’s that showed lower-rated munis defaulted less frequently than higher-rated corporates.
Or the perspective of regulators, who in a rule last year excluded municipal bonds from a class of securities that banks and other financial institutions would be required to hold to fulfill liquidity requirements in case of financial stress.
Change is afoot
For securities that have an extraordinary record of safety and are widely held by investors, it’s hard to explain these anomalies. But change is afoot.
Next month, a new rule, part of the Dodd-Frank financial regulation law, takes effect. It requires rating agencies to make their calls “in a manner that is consistent for all rated obligors and securities.”
The reasons behind it are obvious.
In a report covered in The Bond Buyer, “US Municipal Bond Defaults and Recoveries, 1970-2013,” Moody’s looked at the 10-year cumulative default rate for munis rated Baa1, Baa2 or Baa3. They found it was 0.32%. The default rate for corporates rated Aaa, on the other hand, was 0.49%.
S&P’s recently released default report showed similar results: 10 years after munis were rated BBB-plus, BBB or BBB-minus, 0.42% defaulted. An S&P study last year showed 10 years after corporate bonds were rated AAA, 0.87% defaulted.
A look at recent yields underscores the extent to which municipal bonds are misvalued. For example, the recent average yield for AAA-rated corporate bonds is 2.69%, yet BBB-rated tax-free general obligation municipal bonds are yielding 2.94%, both having 10-year maturities.
That means for the highest earners, the corporate bonds would yield 1.51% after federal taxes, which pales in comparison to the 2.94% yield of tax-free bonds – almost double the corporates – and that doesn’t even factor in state and local taxes.
Over the years, Moody’s and S&P have instituted changes in their criteria that have generally resulted in higher ratings for municipal bonds, but the ratings services clearly don’t give enough credence to the security behind munis.
Explaining the anomaly
A former chief credit officer at S&P offered an astonishing reason why ratings agencies maintain different levels of credit risks for given ratings between munis and corporate bonds: “if you call (all munis) AAA then one is not creating a lot of value” for the user of municipal ratings, Mark Adelson, a former chief credit officer at S&P, told The Bond Buyer.
The rating agencies both told The Bond Buyer that changes in criteria are made periodically. Indeed, Adelson said they have known of ratings divergence between corporate and munis for years – since at least the early 1990s.
Meantime, a House bill was introduced that would require municipal bonds that are investment grade and actively traded in the secondary market to be considered “high-quality liquid assets.” These assets are part of an institution’s requirement to maintain a certain liquidity coverage ratio. The rule is intended to enable banks to fund themselves in the event of an emergency similar to 2008, when a lack of liquidity froze financial markets. Banks have until Jan. 1, 2017, to comply with the rule.
As we discussed previously (“Push is on to Include Munis in New Banking Rule“), the rule was adopted by the Federal Reserve, Comptroller of the Currency and Federal Deposit Insurance Corporation and was widely opposed over fears that banks would reduce their muni holdings and increase borrowing costs for states and municipalities, which rely on tax-free bonds to fund infrastructure projects.
The bill to include munis is backed by a bipartisan group of House members and is said to have a good chance of being approved by the Financial Services Committee.
It’s hard to call munis unloved, as the number of investors who hold tax-frees is soaring. They know the score. Now it’s time raters and regulators catch-up. We hope it doesn’t take another 25 years.