Many investors generally have a tendency to rely on municipal bond ratings to evaluate the credit quality of their chosen muni bonds. It’s a common assumption that whenever a bond’s rating is downgraded there is a probability that the debt will not be repaid on time. Continuous failure to make interest payments constitutes a default. Similarly, whenever a bond is upgraded its opposite holds true and investors have more faith in that specific bond. The below table show the ratings provided by the top three credit rating agencies in the U.S.: Moody’s, S&P and Fitch.

Muni bonds are graded based on the above ratings by each agency. The rating is assigned on the basis of macro- and microeconomic analysis, mainly to determine revenues available to the issuer to cover the debt service. The agencies evaluate the economic well-being of the area. Some of the criteria considered for the evaluation of the bonds include median income, how concentrated the community’s dependence is on certain employers or industries, the diversity of the tax base, the rate of population growth, the population’s age groups, whether tax revenues are going up or down and why, tax rates and whether or not they can be increased without decreasing revenues, if the economic area is undergoing challenges, how affluent the community, city, or state is, etc.

How safe are the revenues of the issuer if it is a revenue bond? Usually bonds are rated for their entire life. But making predictions for any bond beyond five years is difficult as ratings are based on the current economic conditions. When ratings are reviewed, they may change as per the market conditions. As the economic fortunes of the issuer vary, so will the ratings and hence some muni bonds may face major upgrades or downgrades in their lifetime. For example, State of Louisiana bonds were rated AAA in the mid-1980s but by early 1990, they were rated barely investment grade.

The main impact of changes in the ratings of the bond is on interest rates. Credit ratings affect the cost of borrowing. Bonds with the highest quality credit ratings always carry the lowest yields, while bonds with the lowest credit ratings always carry the highest yields. The most creditworthy bonds are issued with very little debt borrowed at a lower cost and hence have high ratings, whereas less creditworthy issuers have to pay higher interest with more debt.

If bonds are downgraded, bond prices decline and if they are upgraded, bond prices increase. Also, bond prices change even with the slightest possible news of an upgrade or downgrade because investors easily gain or lose faith in their investments; they sell bonds whose credit quality is declining and buy bonds whose credit quality is improving. But in reality, unless there is a genuine risk of default, price changes in response to upgrades or downgrades are less concerning than those occurring due to changes in interest levels. For example, for bonds rated AAA a downgrade to AA may not make a noticeable difference in the price.

An investor should always bear in mind certain factors when investing in a muni bond. Always check how the major agencies have rated the bond and buy high-investment-grade bonds depending on your risk tolerance. Try to understand the main reason for the bond’s rating and check ratings periodically. And last but not the least, diversify your bond portfolio by buying bonds from different issuers of varying maturities to diversify interest rate risk.

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