Market participants are calling into question the value of municipal bond ratings in the midst of the coronavirus pandemic, which is dramatically altering the U.S. economy and perceptions of state and local government credit quality.
The nature of how ratings for muni issuers play out in times of severe volatility, such as was experienced in the 2008 financial crisis, is under increased scrutiny. The COVID-19 pandemic has affected all markets and altered life around the globe, forcing municipal issuers and muni market players to view creditworthiness, public policy and healthcare crisis-planning through a necessarily changed lens.
“Rating actions taken now (in the absence of any modern-age understanding of the short- and long-term impacts of a pandemic and related economic shutdown) are less likely to be indications of changes in long-term issuer credit quality than they are to be admissions of short-term unknowns,” said Lisa Washburn, chief credit officer and managing director at MMA, who spent 20 years at Moody’s Investors Service.
This, she said, means “current rating changes that are calibrated to a pre-pandemic methodology and a rating universe less likely to be stable over the short run.”
Major issuers including Illinois, New Jersey, New York, Alaska, Connecticut, Hawaii and the New York Metropolitan Transportation Authority have been hit by downgrades or negative watches from the major rating agencies in the past two months. Many participants expect more to come.
The economic and healthcare crisis caused by the virus — which is leading to potentially the largest short-term tax revenue losses for state and local governments and their agencies in history as the country and its businesses have shut down and revenues simply dry up — bears responsibility for the rating changes.
None of the rating agencies have changed their methodologies due to the coronavirus. S&P Global Ratings, Moody’s Investors Service, Fitch Ratings and Kroll Bond Rating Agency all said they are looking “through the crisis” to allow issuers time to rebound from the tax revenue shortfalls they are facing.
Amy Laskey, managing director of U.S. public finance at Fitch, said: “Fitch's downside case, which considers an even more severe decline in GDP in 2020, is used to inform rating sensitivities and stress-based analysis for higher-rated credits. While not a forecast, the decline in GDP implies a first-year stress to revenues anywhere between two and six times greater than previously considered as part of Fitch's through-the-cycle scenario analysis, though both cases currently call for a significant bounceback in revenues in the outlying years of the scenarios.”
Robin Prunty, managing director and head of analytics and research of U.S. public finance at S&P, said to date the agency has not changed its ratings criteria due to the coronavirus.
“We believe our ratings criteria continue to provide us with a framework that generates relevant forward-looking opinions of overall creditworthiness,” she said.
The agency reviews its methodologies on a regular cycle and, in connection with that process, it monitors and analyzes current and historical performance metrics and market feedback, she said.
S&P rates about 18,000 credits and has downgraded six issuers and revised outlooks on 549 issuers to date in connection with the virus. Prunty said outlook revisions and credit rating actions through April 17 have largely been focused on sectors heavily impacted by the credit pressures associated with the pandemic, including health and safety measures such as social distancing.
“Rating outlooks address the potential for an event or trend to change a rating with a one-in-three likelihood over a period up to two years,” Prunty said. “We expect to continue to update our credit rating opinions as economic data and forecasts become available, in line with applicable methodologies and policies.”
Mike Rowan, managing director and head of U.S. public finance at Moody’s said it takes a mostly post-crisis view because it is not helpful to move the ratings to the lowest point of a given crisis outcome.
“We’re aiming to look through the crisis and orderly rank the credits post-crisis,” he said.
As of Wednesday, Moody’s has put on a negative outlook on Hawaii, Illinois, New Jersey and New York. It has moved outlooks from positive to stable on Oklahoma and Louisiana. The agency has not yet downgraded any states.
Rowan said Moody’s has not seen the need nor the demand to change its methodologies, which are “flexible.” He said the agency is not looking at short-term, severe risks to rate states, but rather how coronavirus could impact revenues and expenses in a long-term setting.
The federal government support through the various stimulus programs should help municipalities regain their tax bases, he said, even if the stimulus isn’t coming in the form of direct dollars allocated to those states and cities. When small businesses return to work, tax dollars will return and the agency views that as a positive for state and city economies.
States, in particular, have strong reserves and debt service payments would not be at risk, according to Rowan. The longer-term risks for issuers, generally, he said, will be pensions, since the stock market has been roiled.
KBRA has no plans to change its municipal methodologies.
"Our methodologies were written by highly experienced analysts, were designed to withstand credit cycles, and are deployed by analysts who know how to use them to assess change in fundamental credit risk based on data, rather than headlines," said Bill Cox, senior managing director, global head of corporate, financial and government ratings.
"It’s important to note that KBRA’s ratings are designed to withstand credit cycles, not to move with credit cycles," Cox said. "While many municipalities are experiencing unprecedented stress to their economies, our analysts are examining each credit on its specific circumstances, and applying specific updates to our assumptions, rather than broad sweeping changes to ratings."
Tax collections are the long-term bedrock of muni bond repayments, and the market is already seeing impairments and potential defaults. However, sources said, many issuers have already baked their bond repayments into their budgets, so investors should not fear the inability to clip their coupons in the near-term for most municipal bond investments.
The ratings business changed dramatically with the 2010 passage of the Dodd-Frank Act, which enshrined in federal law the role rating agencies are supposed to play in capital markets. The law requires agencies, among other things, to develop and adhere to publicly disclosed rating methodologies and to apply rating symbols universally across asset classes. Dodd-Frank created a federal regulatory regime for the agencies, with oversight placed in an Office of Credit Ratings at the Securities and Exchange Commission.
More sophisticated market participants view municipal bond ratings — already a subject of criticism among analysts and issuers alike for years — somewhat moot amidst this turmoil.
MMA's Washburn said issuers now being downgraded are likely to keep getting downgraded, and many may land at a rating level lower than warranted once the crisis abates.
“This situation is less a failing of the individual rating agencies, more of a feature of a system whereby federal regulations require adherence to published methodologies and metrics that conform to historical, rather than emergent, default risk,” she said.
Still, many market participants said rating agencies are not equipped to deal with the uncertainty — and therefore predictability — of what they are rating.
Ratings agencies look at predictability of default, but sources told The Bond Buyer the current state of affairs raises questions about even that foundational principle.
Just as a person might not pay their credit card bill on time in these circumstances, a credit card holder or a muni issuer will likely still pay what they owe when their income (job/tax base) returns. While a cushion might be necessary for issuers, sources said downgrades are muddying the muni waters during a time when clarity is really necessary.
However, pressures mount on rating agencies “during an environment of severe budget and credit deterioration such as the current one,” said veteran municipal market strategist George Friedlander, who spent more than four decades at Citi and its predecessors.
“A key concern for demand-side users of ratings is that ratings may not be reduced as rapidly as credit conditions decline. Rating agencies will be under significant pressure from issuers — who pay the bills, after all — and from existing bondholders, to let the drops in ratings lag declines in credit conditions.”
What do ratings really mean in the age of corona?
When rating a muni, several factors come in to play, MMA said. Should a draw on a reserve for a sales tax bond be treated the same as one for a project financing failing to perform to expectations? And should any payment default warrant a drop to a “D” rating if full recovery is expected in a short period of time? If ratings are dropped to a “D” or a similarly low speculative rating because of a default that is cured in short order, how long should it take before an issuer’s rating recovers?
MMA broached the idea of whether the rating agencies need new symbols to communicate these differences.
Drilling down into the specifics of ratings decisions, the actions on the New York MTA show that the recent downgrades of a notch or two in mid-investment grade territory “captures neither the opinion that there is an imminent risk to the issuer’s solvency nor that it is too big and important to fail and thus will receive the extraordinary support needed,” MMA said.
Direct federal payments to states and instrumentalities are integral to the recovery of the U.S. economy, and the short-term $500 billion borrowing plan that the Federal Reserve was granted through the CARES Act is helping the short-term muni market.
However, the Fed continuing to prop up the larger world economy should be weighing heavier on investor sentiments broadly. Just late Tuesday, the Senate approved another $483 billion package to help small businesses, but did not provide any additional direct support to state and local governments.
The United States itself would likely lose its AAA rating if rating agencies were basing their ratings purely on revenues vs. expenditures, Friedlander and others said. The U.S. is nearly $24.5 trillion in debt and the Fed continues to sell debt to fill the voids.
In 2011, S&P downgraded the USA's AAA rating. That very day Treasuries rallied, with investors signaling to the world that the U.S. was still the gold standard. There is, essentially, no alternative to UST bonds.
Save for munis.
The biggest distinction between the United States Treasury and states and municipalities is that states and localities generally need to balance their budgets. The United States has no such mandate and the Fed can print as many dollars as it deems necessary, so there is very little concern about the country’s AAA rating, according to Friedlander and others.
However, this is also where understanding municipal credit is so important, because next to U.S. Treasuries, munis are the next best thing, sources said, and historical data backs this up.
Rates are still historically low and negative with some global sovereigns. From a relative value proposition, tax-exempt munis still yield more than Japanese and German sovereign debt, which are trading with negative yields. And taxable munis still have a place in foreign investor portfolios, not only for their yields but also from their implied “impact” score that many foreign investors rely on.
The global markets know that a corporation can default, fold and no longer exist. New York City, Chicago, Cleveland, and Missoula, Montana will continue on. The U.S. will still exist. Downgrade it and its states, and it will still be here.
Drilling down further in municipal credits, the mere fact that a state is rated lower than a small “special tax-supported” muni issuer is indicative of how bifurcated this market is.
The lack of focus on smaller, potentially riskier issuers makes some participants question why a U.S. state — Illinois — deserves to be rated lower than a healthcare facility in Massachusetts.
A hypothetical, non-investment grade rating on state of Illinois GOs would be “unintelligible messaging to investors” and would not be directly comparable with other municipal ratings, according to MMA.
“Noting here the thousands of municipal borrowers in senior living, hospitals, project finance, charter schools, and multifamily housing sectors now rated higher than BBB-minus frankly, a junk rating that signals a meaningful and growing risk of payment default by a state on its GO bonds should, theoretically, trigger a mass downgrading of the local governments, schools, and corporations that depend, directly or indirectly, on the state fulfilling its statutory obligations to them and is thus a signal of chaotic economic expectations ahead,” MMA wrote.
A bond being downgraded isn't an indication it will default, though, noted John Bagley, chief market structure officer at the Municipal Securities Rulemaking Board.
Bagley said retail investors should be leveraging their financial professionals' expertiseto manage their portfolios during this time and should not be frightened away from investing in munis because of a few bad ratings headlines. He noted, some sectors are far more affected by the pandemic than others, and it would be a mistake for investors to assume that there is the same blanket effect on all muni debt.
“It’s important for investors to be more involved," Bagley said. "It’s just going to be different.”
The MSRB is maintaining a dedicated COVID-19 information page, and is preparing to release — as soon as next week — an investor education guide spurred by the pandemic.
Bagley said issuers disclose information that may not be reflected immediately n a rating, and he urged investors touse EMMA to receive custom alerts and execute custom searches about bonds they hold.
William Oliver is a municipal research consultant who spent decades as a buy-side analyst and portfolio manager, including 19 years at AllianceBernstein where he rose to become head of municipal research. He said sophisticated investors have realized more and more over the years they couldn’t rely on the rating agencies, and he views the entire rating regime as fundamentally flawed.
“The buy side, I think a long time ago, decided that they needed to be on their own,” Oliver said. “Most buy-side analysts don’t really care about any of this anymore, except that it affects pricing.”
Assigning a rating to New Jersey or Illinois or the New York MTA during a pandemic is vastly different than that job was even a mere month or so ago.
And major asset managers do not want to divulge what and how they are evaluating their portfolios because it is a competitive disadvantage to do so. But the market is yearning for some sort of uniform disclosure and clear messages from issuers, regulators and participants themselves.
Disclosure, of course, will weigh heavily on any investor or rating agency decision on an issuer’s creditworthiness.
Oliver said many firms staffed up on research after the 2008 crisis and the decline of the bond insurance industry, which for years had greatly mitigated the risk of high-yield muni investments.
Institutional inventors have an upper hand since they understand credit better than those who do not have the financial backing or in-house risk analysts on their desks, like the big banks do.
Who pays? The industry knows — it’s the issuers
Oliver said a key problem with the rating system is the issuer-pays model, an old criticism that remains relevant even after the sweeping reform in Dodd-Frank. Issuers pay for ratings, often required for public offerings. This incentivizes them to “shop” for the most favorable ratings, and may also give the agencies an incentive to provide favorable ratings.
“It is the root of the problem,” Oliver said. “If Moody’s gets more conservative, people don’t go there anymore.”
Oliver said SEC oversight of the agencies has not gone far enough, and whilethe methodologies imposed by Dodd-Frank are good for the market they make ratings even less useful for many investors. Before Dodd-Frank, agencies very often agreed on the creditworthiness of issuers, Oliver said, but varying methodologies now create a divergence in how agencies rate different sectors.
“It means even more so you can’t rely on the ratings,” Oliver said, adding this effect rewards firms doing their own research.
The SEC did not respond to a request for comment.
“This is really going to change the way bonds are rated, I think,” Oliver said of the pandemic. He suggests many highly rated issuers might issue deficit-bonds backed by special or temporary taxes, which will force the market to take a look at the system.
“Should a triple-A credit be selling deficit bonds?” he asked.
Looking back at the Great Depression, municipal bond ratings were not a great predictor of default risk, MMA's Washburn said. Of the issuers that defaulted, 78% were rated AA or higher and they accounted for over 94% of the dollar value affected.
The lack of post-depression defaults led the agencies and market participants to conclude that ratings overstated default risk and they enacted widespread rating adjustments.
In the same way, trying to adapt ratings to a pandemic could lead to a similar overstatement of risk in the post-pandemic years, Washburn said.
“Meaning trying to calibrate ratings now to incorporate the current sudden and severe shock may lead to overstating long-term credit risks if the troubles encountered are related to liquidity," she said. "For sure it seems that sector credit quality will take a hit/be lower across the board, but if rating actions are taken using a pre-COVID-19 crisis rubric there could be significant downgrades for draws on reserves and temporary defaults that may be cured relatively quickly when/if the economy reopens.”
Why ratings matter
Not everyone is pessimistic about muni ratings. Friedlander said ratings are actually quite important to this market and it would be a disservice to the industry to discredit them so quickly.
Friedlander said the agencies have access to massive amounts of information that even the strongest institutional investors can’t replicate. They have large numbers of analysts in a wide variety of vantage points that can help identify transitions over time, Friedlander said, adding that he is not aware of any institutional investors that can replicate this depth of knowledge and information on the entire universe of state and local credits.
While the near-term governmental and budgetary implications of the coronavirus crisis may be “extremely difficult to discern using standard rating agency techniques, their value has not completely vanished as a measure of relative credit strength, and of transitions in that credit strength,” Friedlander said.
“Quite simply, in an environment in which the agency rating process did not exist, municipal bonds would be vastly more illiquid and difficult to price. Ratings provide a baseline from which institutional investors can adjust, higher or lower, and make changes over time as more information becomes available. The rating agencies, too, will adapt to the availability of new, better and more complete information—and their changed measurements and perceptions will be fed back into the rating and valuation process.”
The MSRB's Bagley said muni investors should expect to see more rating changes over the coming months than they are accustomed to.
“Ratings are definitely an input you want to have," Bagley said, noting the MSRB provides rating updates on EMMA through agreements with the agencies.
Ratings continue to provide essential information for policymakers, both federal and state/local, Friedlander said.
“When a given issuer or set of issuers goes to Washington to elicit financial support, it is extremely important that they be able to articulate to Congress how much the deterioration of their budgetary process has created new shortfalls that will affect provision of key services and funding of essential projects. Rating changes help in that process,” Friedlander said.
