Credit Ratings: How to Evaluate Muni Bonds

Key Points

  • A bond rating is an opinion of the likelihood an issuer will be able to honor its bond contract and make timely interest and principal payments.
  • We suggest focusing on higher credit quality municipal bonds.
  • Use credit ratings as a starting point for constructing a portfolio of individual munis, and then as a tool to determine if the bond continues to meet your risk tolerance.

How useful are credit ratings when assessing the quality of municipal bonds? We think ratings can be a good starting point when you're looking to build a portfolio of individual munis. They can also be a useful tool for keeping tabs on your bonds to make sure they continue to match your risk tolerance.

Of course, ratings aren't the end-all-be-all measure of bond quality. A bond rating is an opinion from a credit-rating agency such as Moody’s, Standard & Poor’s, or Fitch about how likely it is a bond issuer will make timely interest and principal payments. A high rating isn’t a guarantee against loss and doesn’t take into account potential risks such as how easy it is to sell a bond, which could affect the bond’s price. (For more information on credit ratings, review this SEC bulletin.) Ratings can also change over time.

Here, we’ll discuss the value of credit ratings and what types of ratings we prefer when it comes to balancing risk and reward.

What’s in a rating?

A credit rating is often based on a combination of factors covering everything from the issuers’ financial strength and the legal strength of a bond contract to the economic conditions in the issuer’s area and other factors. These factors change over time, and ratings agencies may change their ratings in response.

When a bond’s rating improves, the market generally takes it as a sign that the issuer has greater financial flexibility to meet its scheduled bond payments. That can cause the bond’s price to rise. The opposite is generally true, too. When a bond is downgraded, its price usually falls. However, a falling credit rating shouldn’t affect regular interest and principal payments unless a bond defaults.

A look at ratings

Source: Standard and Poor’s, Moody’s, and Fitch.

Note: Within ratings categories, both Standard and Poor’s and Fitch use the modifiers “+” or “-” to indicate the relative status within the rating category. Moody’s uses 1, 2, and 3 to indicate relative status with 1 being the highest and 3 being the lowest.

Credit ratings have historically been a good predictor of default—and seem to be doing a better job recently

The ratings agencies came in for some criticism for their failure to predict the 2008 financial crisis, but that shouldn’t discredit them entirely. We don’t think you should “throw the baby out with the bathwater” when it comes to ratings.

For one thing, most of the agencies’ problems came from their assessments of corporate issuers like Lehman Brothers, Bear Stearns and AIG and their inability to judge the risks in complex subprime mortgage backed securities.

Municipal issuers are generally very different. They don’t have the same business risks as corporate finance issuers and their finances generally aren’t as complex as pools of subprime mortgages. Overall, that tends to mean that ratings of muni issuers are generally less prone to surprise revisions. To put this in perspective, when corporate defaults were skyrocketing in 2009—they went from 94 in 2008 to 189 in 20091—only three muni issuers defaulted.

To top it off, muni bond ratings have actually gotten better at predicting default in recent years. In 2008, the highest credit rating for a bond rated by Moody’s that defaulted one year later was Aa2.2 In 2016, the highest rating for a Moody’s rated bond that defaulted one-year later was B3—a Puerto Rico related bond.

Municipal bonds have historically been less prone to default than corporate bonds

Corporate bonds of all credit qualities have defaulted at much higher rates than munis over the last five years, especially at the higher risk end of the spectrum.

Source: Moody’s Investor Services, as of 6/27/2017.

Municipal bond defaults have been rare historically

So how common are defaults? Historically, municipal issuers have done a very good job of honoring their promises to make timely interest and principal payments. Since 1970, there have been only 103 defaults among the tens of thousands of municipal issuers that Moody’s rates. In 2016, only four Moody’s-rated munis defaulted and all were related to Puerto Rico. Puerto Rico had a very low Caa3 rating by Moody’s at the time of default.

Munis can generally be categorized into three different types of issuers:

  • General governments: These cover general obligation bonds from state and local governments or bonds that are supported by special taxes.
     
  • Municipal utilities: These cover issuers of essential service revenue bonds. For example, water and sewer utilities.
     
  • Competitive enterprises: These cover municipal bonds that operate in a more competitive environment like health care and hospitals, or the higher education or housing sectors.

General government and municipal utility issuers tend to cluster around the higher-quality end of the ratings spectrum, as you can see in the chart below. In contrast, the ratings of competitive enterprises tend to vary more and are spread more evenly across the spectrum. Most Aaa rated competitive enterprise bonds are issued by prestigious higher-education providers with very large endowments.

Ratings for competitive enterprises are more dispersed than general governments or municipal utilities

Most general government and municipal utilities issuers carry Aa or A ratings.

Source: Moody’s Investor Services, as of 6/27/2017.

Competitive enterprise issuers are responsible for most muni defaults. This is partly because of the nature of how they operate. For example, healthcare facilities and higher education providers generally don’t have a natural monopoly, as water and sewer providers or transportation systems do. And they don’t have the broad taxing authority of general governments. 

Most municipal bond defaults are by entities that operate in more competitive environments

Historically, competitive enterprises have been responsible for most of the muni defaults going back to 1970.

Source: Moody’s, as of 6/27/2017.

Higher-rated munis have been downgraded less often than lower rated munis

Ratings of higher-rated bonds have also proved pretty durable. For example, higher-rated munis historically have been downgraded less often than lower-rated bonds. Since 1970, munis that were originally rated AAA have been downgraded just 1.7% of the time over the next year, while those rated AA have been downgraded just 1.4% of the time. Lower-rated bonds have proved more likely to slip—Ba- and B-rated bonds have been downgraded 3.7% and 5.2% of the time, respectively, over the next year. When a bond is downgraded its price often falls, which would likely result in a loss if sold prior to maturity.

Where a rating ends up is also important. A ratings downgrade to BBB or below investment grade is more significant, in our view, than a downgrade from AAA to AA. After all, a AA-rated bond is still at lower risk of default than one rated below investment grade. For investors whose primary concern is safety of principal, a downgrade to BBB or below may be a trigger to sell, in our view.

A greater selection of highly rated munis helps with diversification

Given all this, we think investors looking to build a diversified portfolio of muni bonds should start at the higher-quality end of the spectrum. Bonds issued by general governments and municipal utilities should serve as the core of the portfolio, and then bonds from competitive enterprises can be added according to the investor’s ability to tolerate additional risk.

We also suggest muni investors choose at least 10 different issuers with different credit risks. This is easier when choosing between higher-rated bonds because there are simply more of them than there are lower-rated ones. Roughly two-thirds of the investment grade municipal bond market are in the top two rungs of credit quality—AAA and AA.3 For mutual fund investors, the same is also true because it’s easier for fund managers to find high credit quality munis.

Once the portfolio is built, it makes sense to keep an eye out for potential ratings changes. A ratings change provides a good opportunity to review that individual bond and determine if it still meets your risk tolerance. Clients can sign up for ratings alerts on Schwab.com or by contacting their local Schwab representative.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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Important Disclosures