Last year proved to be an object lesson in the need for independent, professional analysis in the municipal bond market.
Investors who look at ratings trends last year from the two major ratings agencies — Moody's Investors Service Inc. and Standard and Poor's — can be forgiven for wondering if the companies were analyzing the same market. This underscores our long-standing belief that investors should look to ratings agencies as just one input in the investment decision-making process.
On one hand, Moody's reported a big increase in the number of muni downgrades. The agency's downgrade-to-upgrade ratio across the U.S. public finance sectors nearly doubled to 4-to-1, from 2.2-to-1 a year ago.
The 2011 downgrades affected $193.5 billion worth of debt (in par value), while upgrades affected just $13.2 billion, according to Moody's.
On the other hand, S&P's upgrades surpassed downgrades last year by 1.32-to-1, excluding the housing sector. Ratings changes in the state and local government sector were positive for the year, with an upgrade-to-downgrade ratio of 1.28-to-1, according to S&P.
MOODY'S RECALIBRATIONS
A big factor behind the different results appears to be recent changes in the Moody's methodology.
In 2010, Moody's issued mass “recalibrations” that affected 70,000 of its ratings, including those for long-term bonds of most state and local governments. Many of the ratings moved higher.
The recalibrations stemmed from an effort to adopt a standard methodology for all borrowers. Moody's was responding to criticism that municipalities were being held to more-stringent standards, despite their stronger histories of repayment and historically lower default rates.
Last year, Moody's took another look at its ratings criteria following the passage of the Dodd-Frank Act, which requires agencies to review their methodology for credit ratings annually. Although the upgrade/downgrade ratios were negative, it is worth noting that just 643, or 3.6%, of the 18,000 issuers rated by Moody's experienced a ratings change last year.
In terms of market reaction, it was mostly a shrug in 2010 during the mass recalibrations, as muni prices didn't materially increase.
But when Moody's downgrade-to-upgrade ratio hit 5.3-to-1 in the third quarter last year, the market rallied, which suggests that investors think that declining credit trends may be at or near their bottom. There is good historical justification for this, as muni credit tends to lag the overall economy in coming out of recessions.
By contrast to Moody's, last year's ratings trend for S&P was little changed.
At the end of last year, 41.5% of U.S. public finance ratings were double-A or higher, which was in line with the 42.3% figure reported at the end of 2010. The number of A ratings was also little changed at 49.7%, compared with 48.9% in 2010.
It is important to keep the different rating trends of the two agencies in perspective. Their task of analyzing the vast, heterogeneous muni market is an enormous challenge, and they seek to improve their processes on a continuing basis.
Moreover, while agency methodology and credit trends sometimes drive price volatility, we think that the longer-term fundamentals are the most important factors in the muni market. That is why, as independent managers, we put our focus on credit research and relative yields.
TURNING TO FUNDAMENTALS
As of today, our outlook for the muni bond market is best described as cautiously optimistic.
Credit trends are stabilizing, but longer-term structural issues such as unfunded-pension liabilities will be an increasingly important issue in the future. For example, while 41 states have undertaken some type of pension reform in the past two years, it is still just a start.
A good reminder of the perils that remain comes from Stockton, Calif., which is discussing declaring bankruptcy in the wake of recent downgrades by Moody's and S&P.
In our view, such issues still have been given insufficient attention and aren't formally incorporated in credit ratings. We think that the muni market will prove to be a rewarding environment for investors who use professional managers that stress credit oversight and look beyond the short-term ebb and flow of credit ratings.
Thomas M. Metzold is co-director of municipal investments and portfolio manager at Eaton Vance Investment Managers.
