Backward-Looking Municipal Bond Ratings: Rating the Raters

Transcription

1 Backward-Looking Municipal Bond Ratings: Rating the Raters The national economy is showing signs of life, state and local tax receipts are on the rise, local budgets are returning to balance and... Moody s and S&P are downgrading more tax-supported credits than they are upgrading. On the surface such rating actions may seem incongruous with the economic conditions. But, in fact, they are all too predictable for those familiar with the municipal market. Ratings assigned by the major public ratings companies are a backward-looking indicator of an issuer s credit worthiness. Put another way, using the ratings companies municipal ratings as barometers of credit is akin to navigating a highway while looking in your rear view mirror: where you ve been may be important, but it does not necessarily show you where you re going. May 2012 Shawn P. O Leary Vice President, Senior Research Analyst - Manager Nuveen Asset Management, LLC RATINGS LAG THE ECONOMIC CYCLE We can see the backward looking nature of ratings by examining the ratings companies own published upgrade and downgrade data. Both Moody s Investors Service (Moody s) and Standard & Poor s (S&P) produce quarterly reports detailing the number of credits they upgrade and downgrade. One can evaluate the predictive value of their ratings by calculating a quarterly upgrade-to-downgrade ratio for tax-supported credits (those backed by property, sales and income taxes or essential service revenues) and comparing these quarterly ratios to the national unemployment rate (used here to track changes in the national economy). Exhibit 1 shows the Moody s upgrade-to-downgrade performance over much of the last decade. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 Exhibit 1: Moody s Upgrade-to-Downgrade Ratio Compared to Moody s Ratio 12% 10% 8% 6% 4% 2% 0% Source: Moody s Ratings Revisions Data, The national unemployment rate is used to track changes in the national economy. Note that these figures do not reflect rating adjustments made by Moody s when it shifted many municipal credits to a global rating scale. This adjustment, which is described in the sidebar, moved scores of issuers one to three notches higher in an effort to make municipal credits more comparable to taxable fixed income ratings. Thus, Exhibit 1 demonstrates Moody s rating actions based on their opinion of credit changes, not rating scale changes. Moody s maintained an upgrade-to-downgrade ratio between 4 and 12 times from the third quarter of 2006 through the second quarter of Though the economy began to show signs of stress in late 2007 and early 2008, Moody s steadily upgraded more tax-backed credits than they downgraded until The ratio remained above 2 times through the first quarter of 2009 before finally falling below 1 times during the second quarter of While not exactly stellar performance, it appears positively conservative as compared to S&P s rating actions. S&P s upgrade-to-downgrade ratio is graphed against the national unemployment rate in Exhibit 2. SIDEBAR: GLOBAL SCALE RATINGS In May of 2010 both Moody s Investors Service and Fitch Ratings (Fitch) moved their municipal ratings from the traditional Municipal Scale to the Global Ratings Scale. Their aim was to make municipal ratings more comparable to ratings assigned to taxable fixed income issuers such as corporations and sovereign nations. Traditional municipal investors, such as Nuveen Asset Management, largely opposed the move because it reduced transparency in the market by homogenizing what was previously a welldefined gradation of credit ratings. The following table shows the degree to which Moody s and Fitch lifted tax-backed and essential service revenue ratings. Rating Migration of General Obligation and Essential Service Revenue Bonds MOODY S FITCH Old Rating New Rating Notches of Lift Old Rating New Rating Notches of Lift Aaa Aaa 0 AAA AAA 0 Aa1 Aa1 or Aaa 0 or 1 AA+ AAA 1 Aa2 Aa1 1 AA AA+ 1 Aa3 Aa2 1 AA- AA 1 A1 Aa2 2 A+ AA- 1 A2 Aa3 2 A AA- 2 A3 A1 2 A- A+ 2 Baa1 A1 3 BBB+ A 2 Baa2 A2 3 BBB A- 2 Baa3 Baa1 or A3 2 or 3 BBB- BBB+ 2 Below Inv. Grade No Change 0 Below Inv.Grade Case by Case Case by Case Source: Recalibration of Moody s U.S. Municipal Ratings to its Global Rating Scale, Moody s Investors Service, March 2010; Recalibration of U.S. Public Finance Ratings, Fitch Ratings, March 25, The new scales adopted by Moody s and Fitch for general obligation and essential service revenue credits initially largely eliminated the BBB rating range, clustering the ratings at the high-quality and sub-investment grade levels. For independent municipal investors that rely upon the ratings companies for credit risk assessment, this amounted to a significant shift in credit risk particularly in the A-rated space with no change in rating nomenclature or other outward indication that the ratings companies made a significant upward shift in credit ratings. 2

3 BACKWARD LOOKING MUNICIPAL BOND RATINGS: RATING THE RATERS MAY 2012 Exhibit 2: S&P Upgrade-to-Downgrade Ratio as Compared to Source: S&P Rating Changes and Ratings Roundup Data, The national unemployment rate is used to track changes in the national economy. From the first quarter of 2002 through the second quarter of 2007 S&P upgraded an average of just over seven tax-backed municipal credits for each one they downgraded. But starting in the third quarter of 2007, just at the onset of the recession, the pace of upgrades swelled to an average of more than 29 times through the third quarter of 2010 (peaking at 73 upgrades to downgrades during the third quarter of 2009). It was not until the third quarter of 2011 when the financial impact of the Great Recession had clearly taken its toll on municipal balance sheets did S&P correct course and its ratio of upgrades to downgrades dipped below 1 times. Another way to analyze the performance of S&P and Moody s is to simply calculate the difference in quarterly upgrades between the two companies. Exhibit 3 displays this quarterly spread and reveals the severe uptick in upgrades S&P undertook during the course of the Great Recession as compared to its largest competitor, Moody s. Exhibit 3: Spread Between Tax-Backed Upgrades Awarded by S&P and Moody s S&P Ratio 12% 10% 8% 6% 4% 2% 0% S&P and Moody s Deviation For each quarter from 2002 through 2007, Moody s and S&P mostly remained within approximately 100 tax-backed upgrades of each other. Beginning in 2008, however, S&P s upgrade volume radically departed from that of Moody s, upgrading 100 to 463 more tax-backed credits each quarter before returning to Moody s pace in late S&P explains the deviation as the result of a methodology review, while also insisting that their drastic increase in upgrades many by multiple notches was not a move to the global rating scale maintained by its competitors. From Nuveen Asset Management s (Nuveen) perspective, whether one describes such rating actions as a shift to a global rating scale or a methodology review is really just a matter of semantics all three agencies (Fitch being the third) lifted thousands of credits for reasons, we believe, that were unrelated to changes in credit profile. WHY ARE THE RATINGS COMPANIES OUT OF STEP WITH THE MARKET? How can the ratings companies maintain such aggressive rating actions when, in the case of the Great Recession, there was such clear evidence that municipal credit was coming under stress? We believe the ratings companies track record is the result of two primary factors: Over-reliance on audited financial data that, in the municipal market, nearly always lags anywhere from 6-18 months. A bias toward issuers and underwriters that arises from the ratings companies conflict of interest resulting from issuers paying for, and underwriters selecting, ratings and ratings companies, respectively. The first point is simply a fact of life for participants in the municipal market: most issuers release financial information only annually, and that is often many months after the close of the fiscal year described in the annual audit. For a more accurate picture of a credit s current and projected financial health, municipal analysts must look to budget documents and talk with issuers. Ratings company analysts appear to depart from Nuveen analysts in their assessment of issuer budgets and financial plans, which gets at the second point highlighted above: a bias toward the issuers and underwriters. When Nuveen analysts Source: S&P Rating Changes and Ratings Roundup Data, ; Moody s Ratings Revisions Data,

4 are evaluating a credit facing some form of financial stress, we evaluate an issuer s plan for addressing that challenge and incorporate the likelihood of success into our internal ratings in a forward-looking way. Ratings companies, by comparison, appear to give greater leniency to issuer plans even those that seem to have a low probability of success and wait to see if the issuer can successfully navigate said challenges before taking a rating action. This practice results in ratings that lag not predict economic and financial changes. Nuveen s view of this situation is informed by our experiences evaluating the same credits covered by the ratings companies, as well as conversations about individual credits with ratings company analysts. Nuveen believes the apparent tendency of the ratings companies to give issuers the benefit of the doubt in such matters, is because issuers pay for the ratings and municipal underwriters will rating shop. Rating shopping is a term used to describe the solicitation of preliminary, nonpublic ratings from the ratings companies and then accepting only the highest one or two ratings offered. Ratings companies are cognizant of the conflict of interest of the issuer pays model and institute various means of mitigating said conflict, but the basic incentives remain. In Nuveen s view, these incentives have helped propel the introduction of global scale ratings by Moody s and Fitch as well as S&P s methodology review that resulted in thousands of upgrades during the peak of the Great Recession. S&P PROPOSES ADDITIONAL RATINGS UPLIFT S&P undertook 4,175 rating upgrades to tax-backed and essential service revenue bonds from 2008 through 2011 (Moody s raised 928 ratings over the same period). Nevertheless, S&P recently released a request for comment regarding a proposal to make their local government ratings more comparable to local and regional ratings throughout the globe. According to S&P which maintains that neither their prior methodology review nor the new proposal constitute global scale ratings the proposal would provide approximately an additional notch upgrade to 32% of their 3,800 local government ratings. Nuveen doesn t support S&P s proposal given that: S&P has already undertaken prior methodological reviews that resulted in widespread, often multi-notch, upgrades to thousands of municipal credits. Rating upgrades unrelated to actual credit improvement serve no logical purpose for investors. More to the point, such upgrades homogenize the rating scale and reduce the transparency and comparability of ratings assigned by S&P. This, in turn, disadvantages retail investors that generally lack independent credit support to see through such rating inflation and properly assess an issuer s credit profile. S&P is accepting comments in response to its request for comment until June 6, WHAT IS AN INDIVIDUAL INVESTOR TO DO? Given the loss of municipal bond insurance, the effects of the Great Recession on municipal balance sheets and inflation of ratings by ratings companies, individual investors in municipal bonds face the most daunting risk landscape in modern times. The ratings provided by the ratings companies lag economic cycles and no longer provide a transparent or comparable gradation of risk upon which to make investment decisions. The key to investing in this new risk landscape is to conduct fundamental and independent credit research on an issuer by issuer basis to determine if the credit profiles in question truly suit an investor s risk tolerance. Absent such due diligence, investors are relegated to back seat passengers as the ratings companies attempt to navigate the highway of municipal credit risk while staring in the rear view mirror. 4

5 RISKS AND OTHER IMPORTANT CONSIDERATIONS This information represents the opinion of Nuveen Asset Management, LLC and is not intended to be a forecast of future events and this is no guarantee of any future result. It is not intended to provide specific advice and should not be considered investment advice of any kind. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell specific securities or investment products. All investments carry a certain degree of risk, including possible loss principal and there is no assurance that an investment will provide positive performance over any period of time. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style of manager. Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc. SOURCES Recalibration of Moody s U.S. Municipal Ratings to its Global Rating Scale, by Moody s Investors Service, March Recalibration of U.S. Public Finance Ratings, by Fitch Ratings, March 25, Bureau of Labor Statistics. U.S. Public Finance Rating Revisions, by Moody s Investors Service, Issued Quarterly Standard and Poor s Ratings Changes and Ratings Roundup Data, Issued Quarterly Request for Comment: U.S. Local Governments: Methodology and Assumptions, by Standard and Poor s, March 6, GPE-BCKRTE-0512P Nuveen Investments 333 West Wacker Drive Chicago, IL