US Municipal and Tax-Exempt Ratings

Municipal Ratings are opinions of the investment quality of issuers and issues in the US municipal and tax-exempt markets. As such, these ratings incorporate Moody’s assessment of the default probability and loss severity of these issuers and issues. The default and loss rates for Moody’s municipal long-term rating scale differs from Moody’s general long-term rating scale.

Municipal Ratings are based upon the analysis of four primary factors relating to municipal finance: economy, debt, finances, and administration/management strategies. Each of the factors is evaluated individually and for its effect on the other factors in the context of the municipality’s ability to repay its debt.

Municipal Long-Term Rating Definitions:

Aaa

Issuers or issues rated Aaa demonstrate the strongest creditworthiness relative to other US municipal or tax-exempt issuers or issues.

Aa

Issuers or issues rated Aa demonstrate very strong creditworthiness relative to other US municipal or tax-exempt issuers or issues.

A

Issuers or issues rated A present above-average creditworthiness relative to other US municipal or tax-exempt issuers or issues.

Baa

Issuers or issues rated Baa represent average creditworthiness relative to other US municipal or tax- exempt issuers or issues.

Ba

Issuers or issues rated Ba demonstrate below-average creditworthiness relative to other US municipal or tax-exempt issuers or issues.

B

Issuers or issues rated B demonstrate weak creditworthiness relative to other US municipal or tax- exempt issuers or issues.

Caa

Issuers or issues rated Caa demonstrate very weak creditworthiness relative to other US municipal or tax-exempt issuers or issues.

Ca

Issuers or issues rated Ca demonstrate extremely weak creditworthiness relative to other US municipal or tax-exempt issuers or issues.

C

Issuers or issues rated C demonstrate the weakest creditworthiness relative to other US municipal or tax-exempt issuers or issues.

Note: Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating category from Aa through Caa. The modifier 1 indicates that the issuer or obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. 

Curious as to what a ‘AAA’ or ‘BB’ rating on a bond actually means? View detailed descriptions of what constitutes each of S&P’s ratings below.

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Long-Term Issue Credit Ratings

Issue credit ratings are based, in varying degrees, on the following considerations:

· Likelihood of payment—capacity and willingness of the obligor to meet its financial commitment on an obligation in accordance with the terms of the obligation;
· Nature of and provisions of the obligation;
· Protection afforded by, and relative position of, the obligation in the event of bankruptcy, reorganization, or other arrangement under the laws of bankruptcy and other laws affecting creditors’ rights.

Issue ratings are an assessment of default risk, but may incorporate an assessment of relative seniority or ultimate recovery in the event of default. Junior obligations are typically rated lower than senior obligations, to reflect the lower priority in bankruptcy, as noted above. (Such differentiation may apply when an entity has both senior and subordinated obligations, secured and unsecured obligations, or operating company and holding company obligations.)

AAA
An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.

AA
An obligation rated ‘AA’ differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong.

A
An obligation rated ‘A’ is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rated categories. However, the obligor’s capacity to meet its financial commitment on the obligation is still strong.

BBB
An obligation rated ‘BBB’ exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.

BB
An obligation rated ‘BB’ is less vulnerable to nonpayment than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to the obligor’s inadequate capacity to meet its financial commitment on the obligation.

B
An obligation rated ‘B’ is more vulnerable to nonpayment than obligations rated ‘BB’, but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on the obligation.

CCC
An obligation rated ‘CCC’ is currently vulnerable to nonpayment, and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitment on the obligation.

CC
An obligation rated ‘CC’ is currently highly vulnerable to nonpayment.

C
A ‘C’ rating is assigned to obligations that are currently highly vulnerable to nonpayment, obligations that have payment arrearages allowed by the terms of the documents, or obligations of an issuer that is the subject of a bankruptcy petition or similar action which have not experienced a payment default. Among others, the ‘C’ rating may be assigned to subordinated debt, preferred stock or other obligations on which cash payments have been suspended in accordance with the instrument’s terms or when preferred stock is the subject of a distressed exchange offer, whereby some or all of the issue is either repurchased for an amount of cash or replaced by other instruments having a total value that is less than par.

(Obligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’, and ‘C’ are regarded as having significant speculative characteristics. ‘BB’ indicates the least degree of speculation and ‘C’ the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions.)

D
An obligation rated ‘D’ is in payment default. The ‘D’ rating category is used when payments on an obligation are not made on the date due even if the applicable grace period has not expired, unless Standard & Poor’s believes that such payments will be made during such grace period. The ‘D’ rating also will be used upon the filing of a bankruptcy petition or the taking of similar action if payments on an obligation are jeopardized. An obligation’s rating is lowered to ‘D’ upon completion of a distressed exchange offer, whereby some or all of the issue is either repurchased for an amount of cash or replaced by other instruments having a total value that is less than par.

Plus (+) or minus (-)
The ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.

NR
This indicates that no rating has been requested, that there is insufficient information on which to base a rating, or that Standard & Poor’s does not rate a particular obligation as a matter of policy.

Short-Term Issue Credit Ratings

A-1
A short-term obligation rated ‘A-1′ is rated in the highest category by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is strong. Within this category, certain obligations are designated with a plus sign (+). This indicates that the obligor’s capacity to meet its financial commitment on these obligations is extremely strong.

A-2
A short-term obligation rated ‘A-2′ is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher rating categories. However, the obligor’s capacity to meet its financial commitment on the obligation is satisfactory.

A-3
A short-term obligation rated ‘A-3′ exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.

B
A short-term obligation rated ‘B’ is regarded as having significant speculative characteristics. Ratings of ‘B-1′, ‘B-2′, and ‘B-3′ may be assigned to indicate finer distinctions within the ‘B’ category. The obligor currently has the capacity to meet its financial commitment on the obligation; however, it faces major ongoing uncertainties which could lead to the obligor’s inadequate capacity to meet its financial commitment on the obligation.

B-1.
A short-term obligation rated ‘B-1′ is regarded as having significant speculative characteristics, but the obligor has a relatively stronger capacity to meet its financial commitments over the short-term compared to other speculative-grade obligors.

B-2.
A short-term obligation rated ‘B-2′ is regarded as having significant speculative characteristics, and the obligor has an average speculative-grade capacity to meet its financial commitments over the short-term compared to other speculative-grade obligors.

B-3.
A short-term obligation rated ‘B-3′ is regarded as having significant speculative characteristics, and the obligor has a relatively weaker capacity to meet its financial commitments over the short-term compared to other speculative-grade obligors.

C
A short-term obligation rated ‘C’ is currently vulnerable to nonpayment and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation.

D
A short-term obligation rated ‘D’ is in payment default. The ‘D’ rating category is used when payments on an obligation are not made on the date due even if the applicable grace period has not expired, unless Standard & Poor’s believes that such payments will be made during such grace period. The ‘D’ rating also will be used upon the filing of a bankruptcy petition or the taking of a similar action if payments on an obligation are jeopardized.

Dual Ratings

Standard & Poor’s assigns “dual” ratings to all debt issues that have a put option or demand feature as part of their structure. The first rating addresses the likelihood of repayment of principal and interest as due, and the second rating addresses only the demand feature. The long-term rating symbols are used for bonds to denote the long-term maturity and the short-term rating symbols for the put option (for example, ‘AAA/A-1+’). With U.S. municipal short-term demand debt, note rating symbols are used with the short-term issue credit rating symbols (for example, ‘SP-1+/A-1+’).

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This Moody’s study, released in 2002, examines historic default rates among all Moody’s-rated municipal bonds between 1970-2000. 

The key highlight is that of all of the municipal bond issues rated by Moody’s over this 30 year span, there were a total of 18 defaults. 10 of the 18 defaults were hospital-related. The study examines the characteristics of each default.

moody’s municipal bond default study-1970-2000 in PDF

The primary concern of all bond investors is whether they will ultimately get their money back. This is especially the case with municipal bond investors: Municipal bond investors willingly accept lower yields compared to other fixed income investments primarily due to the safety record of municipal bonds.

When an issuer fails to live up to the payment obligations of a particular bond issue, the bond is considered to be in default. However, when an issuer misses an interest payment or fails to pay back the principal on the scheduled date, this does not necessarily mean that the investor will not get some or all of their money back. With municipal bond defaults, investors many times get most of their money back. The amount of money that the investor receives from a bond investment that has defaulted is known as the recovery rate.

The 3 largest ratings agencies, Standard & Poor’s, Moody’s, and Fitch Ratings, have each produced a case study examining default risk and recovery rates of municipal bonds. We will summarize the findings from each of these studies below. Investors may also click on the following links to directly access the three studies.

Fitch Ratings:

Default Risk and Recovery Rates on U.S. Municipal Bonds

Standard & Poor’s:

U.S. Municipal Rating Transitions and Defaults, 1986-2009 

Moody’s

Moody’s Municipal Bond Rating Scale

http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20pages/Credit%20Policy%20Research/documents/current/2001700000407258.pdf

Summary:

Each of the 3 ratings agencies assigns ratings to various municipal bond issues as a part of their business; the ratings classify credit risk just as an individual’s credit score is used to assess credit risk. Generally, a municipal issuer such as a school district or a state pays the rating agency to have an upcoming bond issue rated. Just as with individuals, the better the credit rating, the cheaper it is for the issuer to borrow money. The ratings agency analyzes the various risk factors associated with a particular bond issue and the issuer. Based on the rating agencies assessment of the risk factor, the issuer is assigned a credit rating (Aaa, AAA, Baa, etc…).

In its 2003 study, Fitch Ratings concluded the following:

Based on two studies released in 1999 and 2003, Fitch reviewed all municipal bond defaults between 1987-2002. Based on the results of its findings, Fitch Ratings came to conclusion that the different types of municipal bonds fit into three categories of default risk….Class 1, Class 2, and Class 3.

Class 1, the safest category, is comprised of most local and state general obligation bonds. Class 1 also includes general obligation and revenue bonds issued by established authorities with no competition or natural monopolies in essential public services. Altogether, Class 1 includes the following types of bond issues:

-       State general obligation bonds

-       Local general obligation bonds

-       Local school districts

-       Appropriation-backed and tax-backed debt of local and state governments

-       Public power distribution

-       Water and Sewer Authorities

-       Public higher education

-       Single family housing

In this category of issuers, the cumulative default rate between 1987-2002 was .24%; the comparative default rate during this same period for AAA-rated global corporate debt was .43%.

Class 2 from a default perspective is comprised of public service enterprises providing essential services, but where the enterprise is subject to competition or fluctuation in demand. The bonds issued in Class 2 are generally revenue bonds providing services such as:

-       Public power generation (as opposed to distribution which is in category 1)

-       hospitals

-       waste disposal

-       private colleges and universities

-       military and state multifamily housing

-       museums and stadiums

-       airports and seaports

-       toll roads with established traffic patterns

In Class 2, the five-to-fifteen year cumulative default rate between 1987-2002 was .70%; the comparative default rate during this period for AA-rated corporate bonds was .73%. The types of bonds in Class 2 have a similar default rate to AA-rated corporate bonds according to the Fitch Ratings study.

In Class 3, the issuers are comprised of entities that compete with private enterprises and have highly unpredictable or volatile revenue streams. These types of issuers include:

-       Nursing homes and continuing care retirement facilities

-       Industrial development bonds

-       Local Multifamily housing

-       Toll roads without established traffic patterns

-       Tobacco bonds

-       Tribal gaming

In Class 3, the five-to-fifteen year default rates of 3.65% are comparable to 3.97% for ‘BBB+’ rated corporate bonds.

An interesting assessment made by the Fitch study is that Fitch expects that even if the ratings are similar, a single A-rated airport bond will have a higher expected default rate than a state or school district also rated single A. This should lead an investor to place an emphasis on the type of bond issue being considered in addition to the bond’s rating. Municipal bonds rated similarly can have vastly different characteristics. According to this Fitch study, the type of issuer and issue is as important as the credit rating when evaluating the likelihood of future default.

Recovery Rates:

When a municipal bond defaults, the investor generally will still receive some money back from their investment; this is known as the recovery rate. In some cases and with certain types of issuers, the recovery rate can be as high as 100% or 100 cents on the dollar. In some cases, a temporary default on interest payments can be cured with some late payments from the issuer and the issuer can resume servicing the debt once again according to schedule.

Comparing different categories of municipal bonds to corporate bonds maybe accurate in terms default rates, but the recovery rates are another matter according to Fitch. Corporate bonds have an average recovery rate of about 40% or 40 cents on the dollar.

Fitch in this study creates 6 classes of recovery rates. The first 3 classes are assumed to have recovery rates of 100% of the principal. 

Class 1: 

-       State GO debt

-       State sales tax backed debt

In the event of default in this class, Fitch assumes a recovery rate of 100% of the principal amount with an assumed loss of 1-years interest.

Class 2:

-       Local general obligations

-       Local tax-backed debt

-       Transit authorities

-       Water, sewer, gas

-       Public colleges and universities, GO and tuition-revenue backed

-       Single family housing

For Class 2, Fitch assumes a recovery rate of 100% of the principal with 2-years of missed interest payments.

Class 3:

-       local and state leases, certificates of participation, and appropriation-backed

-       Airports and seaports

-       Power distribution

For Class 3, Fitch’s model assumes a recovery rate of 100% with 5-years of missed interest payments.

Class 4:

-       Waste disposal

-       Nursing homes and retirement facilities

-       Private colleges and universities

-       Established Bridges and roads

-       Museums and stadiums

-       Public power generating facilities

-       State and local multifamily housing

For class 4, Fitch’s model assumes a recovery rate of 90%.

Class 5           

-       military housing

-       start-up and new bridges and toll roads

For Class 5, Fitch’s model assumes a recovery rate of 70%.

Class 6:

-       private prison

-       stadiums

-       student housing

-       private university bonds backed by auxiliary revenues

-       hospitals

-       tribal gaming

For Class 6, Fitch assumes 40% recovery rates.

Fitch doesn’t explicitly address where many other types of bonds such as industrial development bonds, tobacco securitizations, etc..

Conclusion:

The way an investor would use this information is by being aware of the default risk and recovery rates of various categories of municipal bonds. Rather than simply relying on a rating or a recommendation, information such as this historical analysis from Fitch Ratings should provide you an additional set of data points in helping you understand the risks of investing in municipal bonds.

Investors should be aware that this is simply one analysis done by Fitch Ratings in 2003 and the information should be considered as an educated opinion based on a historical analysis of municipal bond defaults.