CDFA Spotlight: The Rating Agencies By Stan Provus

Overview

The credit rating agencies are companies that analyze the probability of a debt instrument, like municipal bonds, returning the entire principal to the bondholder. Their opinion of the creditworthiness of a particular municipal bond is based on relevant risk factors. These risk factors can vary with the type of municipal bond subject to analysis. Ratings are important because there is typically an inverse relationship between ratings and the interest rate an issuer pays on a tax-exempt bond—the higher the rating, the lower the interest rate. A rating is not a recommendation to purchase, sell, or hold a bond, as it does not comment on market price or the suitability of a financial obligation for any particular investor. Some mutual funds, institutions, and investment trusts are restricted by law to buy securities at a specified rating level. Generally, the credit rating is the most important factor in determining the interest rate on bonds relative to other issues sold at the same time.

The tables at the end of this article describe the various credit ratings for Moody’s, Standard and Poor’s, and Fitch. Each rating agency maintains separate rating scales for long-term debt (generally more than one year) and short-term debt (less than one year).

The Rating Process

While the rating process may vary somewhat among the rating agencies, the process described here is generally applicable to all of them. The rating process for a municipal bond begins with a request for a rating, which may be made in writing or by telephone, by the issuer, its financial adviser, or the underwriter. A formal written application is not required. It has been my experience that many rating analysts will also offer unofficial comments on the prospects of a rating in a given rating category before a formal request is made.

A request for a rating should be made well in advance of the expected sale date to provide adequate time for credit analysis, face-to-face meetings or on-site visits (if necessary) as well as the timely release and publication of the rating—ratings are released by request. The rating services prefer applications two-four weeks in advance of a sale but understand that market conditions may require a shorter time frame. The process could be longer for a first time issuer or deal that requires a meeting or on-site visit. Repeat issues can often get shorter schedules. Analysts do not provide rating fees—another department will provide these.

Information requirements will vary based on the type of bond for which a rating is requested. For a school district bond, information on enrollment trends will be required while a resource recovery project supported by revenues will require engineering studies dealing with operating projections and project feasibility. Credit analysts at the rating agencies will examine historical trends and current conditions and prepare projections to make evaluations about future performance. Both quantifiable and nonquantifiable factors and a variety of documents are examined.

In the case of VRDO IDBs secured by letters of credit, the rating agencies will provide short-term liquidity ratings to assess the ability of the LOC liquidity provider to make timely payment of the purchase price on optional and mandatory tender dates in the event of a failure to remarket the bonds. VRDO investors have the right to put bonds back to the issuer often on 30 days notice and while it is rare that the remarketing agent can not sell the bonds to another investor, in the event they cannot the LOC provider must step in and buy them. The rating agencies will closely scrutinize the liquidity agreement to assure that the liquidity provider has a reliable obligation to provide payment of the purchase price in the event of a failed remarketing.

The rating analyst performs the research and analysis needed to determine the creditworthiness of a bond issue. To prepare a rating recommendation, the analyst evaluates all the information presented by the issuer, and in addition may look to the rating agencies database of public finance information. For example, these databases include extensive information, including a range of demographic and labor market data about localities across the nation and selected financial information. Demographic and labor market data is central to general obligation and many revenue bond issues. Issuers and their representatives are frequently asked to provide additional credit information and respond to questions raised by analysts.

The rating process may include face-to face meetings or on-site visits with issuers or their representatives. These meetings are more common for an issuer’s first debt issue, large and complex issues, or if major changes have occurred in an issuer’s underlying credit factors (positive and negative)

When data collection and analysis have been completed, the analyst prepares a rating recommendation that may first be presented to senior members of the public finance department and then to a rating committee, which consists of senior members of the public finance department. The ultimate rating decision rests with this rating committee, which evaluates the information presented, reaches a consensus, and then officially assigns the rating.

Are Ratings Cost Effective?

The primary rating agencies in the municipal marketplace are Moody’s Investors Service, Inc., Standard and Poor’s, and Fitch Ratings. Bond issuers pay a fee for a rating opinion offered by one of the rating services. In many instances, ratings are cost effective but in some cases they may not be, particularly for very small transactions. Issuers or their underwriters or financial advisers should analyze the cost effectiveness of ratings, since they may not always be cost effective. For example, it is not uncommon for small issue bonds for manufacturers to be sold on an unrated basis when Variable Rate Demand Obligation bonds are secured by rated bank letters of credit (IDBs). Formal ratings on smaller IDBs may not be cost effective if issue amounts are less than a couple of million. This is because unrated VRDO IDBs often trade only 5-10 basis points higher than rated issues. Even though the issue is not rated, the market still recognizes the financial strength of a rated letter of credit provider. Its also important to understand that just because you have a highly rated bank LOC securing an issue, this does not translate into a rating on the bonds unless formal application is made to a rating agency for a rating.

Present value calculations can determine the cost effectiveness of ratings, if you know how bonds would trade with and without a rating. For example, assume:

• 2.5 Million and $5 million VRDO small issues secured by a rated bank LOC;
• 10-year maturity;
• 6% discount rate;
• 5 basis point lower rate for rated issue; and
• $18,500 upfront rating fee, with no annual fee

• A rating on the $2.5 million IDB would not be cost-effective (net present value=($9,300)
• A rating on the $5 million IDB would be breakeven (net present value $100)
• Ratings on issues of more than $5 million would be cost effective

• Long-term credit ratings (issues with maturities of more than 13 months) to varying degrees are based on the following considerations:
• Likelihood of repayment based on the terms of the obligation;
• Nature of and provisions of the obligations; and
• Protection afforded by and relative position of, the obligations in the event of bankruptcy, reorganization, or other laws under the laws of bankruptcy or laws affecting creditor rights.

Credit Risk	Moody’s*	Standard & Poor’s**	Fitch Ratings**
Investment grade
Highest quality	Aaa	AAA	AAA
High quality (very strong)	Aa	AA	AA
Upper medium grade (strong)	A	A	A
Medium grade	Baa	BBB	BBB
v
Not investment grade
Lower medium grade (somewhat speculative)	Ba	BB	BB
Low grade (speculative)	B	B	B
Poor quality (may default)	Caa	CCC	CCC
Most speculative	Ca	CC	CC
No interest being paid or bankruptcy petition filed	C	D	C
In default	C	D	D

** The ratings from AA to CC by Standard & Poor’s and Fitch Ratings may be modified by the addition of a plus or minus sign to show relative standing within the category.

Corporate and Municipal Ratings

A recent Bond Buyer article highlighted the disparity between corporate and municipal bond ratings. The criteria used to assign corporate and municipal ratings, respectively, are not the same. As a result, some analysts argue that the current rating scales do not give investors a way to compare relative credit risk. Almost all analysts argue that a muni credit is safer than a corporate credit with the same rating—many would argue that in many cases a muni rating with a somewhat lower rating than a corporate credit is also safer.

Default studies by the rating agencies have found that AAA-rated corporate bonds are almost twice as likely to default as muni bonds backed by state general obligation, taxes, or appropriations. Some rating agencies are examining ways to bridge the gap between corporate and municipal ratings. Some issuers also say that their taxable needs are met cost effectively in the municipal market—better than their AAA-rated corporate counterparts.

Sources: An Issuer’s Guide to the Rating Process, Moody’s Investor Service; Public Finance Criteria 2005, Standard and Poor’s; Bond Buyer; Security Industry and Financial Markets Association web site and links.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.