Does the market trust corporate issuers more?
Darrell Preston of Bloomberg News wrote a great piece comparing the yields on trades of comparably rated corporate and municipal bonds. He highlighted that corporate bonds have a much higher risk of default than municipal bonds but have similar yields. His analysis suggests that risk is not being properly priced if in fact ratings between asset classes are comparable and that municipal issuers are paying interest rates that are too high.
Two years after Moody’s Investors Service and Fitch Ratings changed standards to put municipal credits on the same footing as corporates, California and Illinois are among states that still pay more for debt than similarly or lower-rated corporations, according to data compiled by Bloomberg. Yet Moody’s says companies default at 86 times the municipal rate.
“Taxpayers continue to get a raw deal,” said Tom Dresslar, spokesman for California Treasurer Bill Lockyer, who pressed for the rating changes. “Not much has changed.”
Preston’s article compares the yield for recent trades for the state of California and a private energy producer, which are rated at near-equivalent levels:
When California and A2 rated Idaho Power both sold 30-year debt this month, the utility’s bonds priced 6 basis points lower than California’s … according to data compiled by Bloomberg. The Boise company provides electricity for southern Idaho and eastern Oregon. The state is rated one step higher at A1 and offers tax-exempt securities to provide an incentive to investors to accept a lower yield.
Preston’s article addresses one of the most fundamental issues of the fixed-income markets. If credit rating agencies are doing their job accurately and rating bonds with similar risk at the same rating category, why is the market pricing the debt as if they are different?
Bob Nelson, who leads Thomson Reuters Municipal Market Data group responded to Preston’s article in a tweet of less than 140 characters:
Bob Nelson @BNels22 you can blame tax-exemption, serial bond structure, poor disclosure for #muniland yield disparity http://bloom.bg/IaZB8t
How risky is that rating?
The Municipal Securities Rulemaking Board’s data platform for municipal bonds, EMMA, recently added credit ratings from Fitch and Standard & Poors to the system. This makes it really simple for investors to get a snapshot of the relative risk of one bond over another when doing research.
Typically the higher the rating, the lower the likelihood that a bond will default. New rules issued in 2008 for credit rating agencies required them to disclose the quantitative results of their ratings and show over time how many bonds defaulted in each rating category. This allows investors to map the performance of ratings over time and allows comparisons between agencies. The system looks at the occurrence of default 1, 3 and 10 years after the bond was issued.
The SEC views default statistics as a window into the accuracy of credit rating agencies’ analysis. Raters are required to publish this data, separated into bond classifications, on an annual basis on SEC Form NRSRO (Fitch’s 2011 NRSRO). I published the comparable data for municipal bonds from Standard & Poors in August. The two raters are broadly similar but not identical.
Investing in municipal bonds does have risk. Looking at default data is the best way to understand how much.
Fitch Ratings One-, Three-, and 10-Year Default Rates By Rating Modifier for Public Finance (%) 2010
How Jefferson County trips up national reporters
The New York Times really needs to improve the quality of its reporting on the municipal bond market. Mary Williams Walsh makes such a terrible hash of the situation in Jefferson County, Alabama, that she is bound to set off another muniland hysteria in the mold of Meredith Whitney.
In the opening paragraphs, Walsh contends that general obligation bonds (GO) issued by state and local governments and with the pledge of their “full faith and credit” may not be as creditworthy as always assumed. About half of the $3.7 trillion municipal bond market is general obligation bonds. She dramatically states that investors who own GO bonds might be in for a “surprise:”
People who own what is considered the safest type of municipal bond may be in for a surprise.
This safe debt, called a general-obligation bond, is said to be the next strongest thing to Treasuries because it is backed by a “full faith and credit” pledge. That means the government that issued it will pay it on time, no matter what.
But now Jefferson County, Ala., has stopped paying such debt, breaking with convention and setting up a fundamental test of what full faith and credit truly means.
What goes unmentioned is that the halted debt repayment is happening in the context of an insolvent county in bankruptcy. More importantly, general obligations bonds can be very high-quality from a strong issuer with top credit ratings, or they could be very low-quality from a near-insolvent municipality with the lowest possible credit ratings. The type of the bond is no assurance of ability to repay bondholders.
The point of a municipality seeking bankruptcy court protection is to halt the legal actions of creditors, including GO bondholders. This gives debtors time and a safe space to reorganize their finances. It’s not in any way “breaking with convention” to halt paying GO bondholders in bankruptcy.
The U.S. Federal Court system’s bankruptcy guide (page 49) describes Chapter 9 municipal bankruptcy:
The purpose of chapter 9 is to provide a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.
One of the major challanges in the Jeffco Chapter 9 is that the securities at issue are not Bonds, they are Warrants. There appears to be an important question under Alabama law whether a municipality (like Jefferson County) can unilaterally act to raise taxes in order to satisfy these Warrants (assuming Jefferson County even wanted to voluntarily do so)without State approval.
We are currently investigating possible legal claims against certain parties involved with the underwriting of these Warrants.
TURNER LAW OFFICES, LLC
hturner@tloffices.com
Notice: The purpose of this posting is to identify select issues that may be of interest to readers. Under Georgia’s Code of Professional Responsibility, portions of this communication may constitute attorney advertising. This posting should not be construed as legal advice or opinion, and is not a substitute for the advice
Muniland’s dynamic living entities
This is an absolutely perfect muniland discussion between Matt Fabian of Municipal Market Advisors, Tom Keene of Bloomberg Television and David Kotok, chief investment officer at Cumberland Advisors. For people unfamiliar with the muni market it really shows how fluid and dynamic conditions are for state and local issuers. It’s really worth listening to several times.
Matt Fabian is one of muniland’s brightest stars and really does an excellent job debunking some common myths about muniland. For example, some predicted there would be hundreds of billions of dollars lost in municipal defaults this year; so far there has been $1.2 billion. For a year Fabian has been saying we would not have a lot of defaults.
It’s at minute mark 6:50, though, where I would challenge Fabian. Contrary to conventional wisdom, as well as the signals from credit ratings and credit-default swaps, he says he would buy the state bonds of California and Illinois. These two are considered some of the worst of state issuers with very heavy debt burdens. Fabian’s rationale is that there are “structural protections for bondholders,” meaning that state law has deemed interest and principal payments to bondholders more important than any other payments the state is required to make.
But the thing I wonder about and would challenge Fabian on is the increasing use of bank loans by state and local borrowers. For example in July of this year California borrowed $5.4 billion as a bridge loan from Wall Street in case the federal government shut down and halted payments to states. California quickly repaid the loan and they have done a good job of disclosing the terms of their borrowing. Nevertheless, states and municipalities have no legal requirement to disclose these borrowings. They are really off balance sheet, at least until their annual audited financial statements are filed, which can mean a delay of a year or more. The MSRB has been examining muni bank loans and has asked the SEC for more guidance. From Bloomberg:
Officials with the Municipal Securities Rulemaking Board, which writes regulations for the $2.9 trillion tax-exempt bond market, have discussed the issue with the Securities and Exchange Commission, Alan Polsky, chairman of the MSRB, said on a conference call with reporters today.
“The SEC and the MSRB are both concerned about bank loans,” Polsky said.
Standard & Poor’s in July estimated that municipalities may borrow as much as $75 billion from banks this year, while Fitch Ratings has also said localities should disclose information about such direct deals with banks. The MSRB, based in Alexandria, Virginia, said in August that loans could fall under some securities rules. It is urging the SEC to weigh in on the matter.
The loans may leave investors unaware about rising debt obligations that could affect their credit ratings, Polsky said.
So Fabian is right to reference “structural protections” for bond payments. But it’s the dark, unknown borrowing that might have more seniority that we don’t know about.
Cutting the ratings agencies the tiniest bit of slack
After polluting the global financial system with hundreds of billions of dollars of overrated mortgage-backed securities and helping bring down the world economy, the credit rating agencies have been struggling mightily to repair their reputations. It’s been an uphill climb, and they were dealt another blow on Friday when a Bloomberg piece detailed academic research showing how fees influenced the assignment of higher ratings. Municipal issuers got the harshest ratings because they paid the lowest fees, according to the article.
Although higher fees definitely played a part in inflated ratings, I think there are a lot more powerful market forces at work than the study and article suggest. The academic study that the Bloomberg piece highlighted – Jess Cornaggia, Kimberly Cornaggia and John Hund’s “Credit ratings across asset classes: A ≡ A?” — focused on 30 years of data from one rating agency, Moody’s. From that data, the authors extrapolated the results to all the major raters. Here’s what Bloomberg had to say:
While the study was based on Moody’s data, it would find about identical results with data from S&P and Fitch because each firm’s grades closely track each other, Cornaggia said in an Oct. 14 e-mail.
If you work around credit markets you realize that although raters can track each other, there are often “split ratings,” or situations where the raters assign different levels to the same security or issuer. Another difference between the raters is that some move faster than others to downgrade. Fitch is typically known as the most aggressive rater in downgrading.
Practically every law and regulation that references credit ratings has a requirement for two ratings. If every rater were identical to the others, it would be redundant for laws to require two. The need for two ratings reflects the undesirability of relying on only one agency.
But put that all to the side for now. The biggest miss in the Corneggia study and the Bloomberg article is the behavior of issuers who “rating shop” and push the different agencies to inflate ratings. The Corneggia study essentially lays all the blame on the agencies for ratings inflation, but I’d suggest that the behavior of sophisticated issuers contributes a lot to the problem, too. Here’s what Columbia Law professor John Coffee told the Senate Banking Committee in September 2007:
In “Myth #13: It’s Best to Follow Expert Advice” of my book “Jackass Investing: Don’t do it. Profit from it.,” I recount the key role the credit ratings agencies played in causing the financial crisis of ’08. You can read that chapter using this complimentary link:
http://JackassInvesting.com/lookinside/l ookinside_myth_13-31.php
Mike Dever
Cities: educated and indebted
Thomson Reuters Municipal Market Data muniland expert Daniel Berger reminded me of a report that I had forgotten about that shows the correlations between the low credit ratings of Ohio’s cities and the cities’ very low levels of college graduates. Dan posits that Ohio, as part of America’s Rust Belt, didn’t require high levels of education for staff at its manufacturing plants and, accordingly, didn’t develop large college-educated workforces. As manufacturing moved out of the region, it left behind cities where the workforce was not attractive to high-tech industries and other sectors that required more educated workers. The cities declined and their credit ratings suffered. Such is the devastating effect of globalization.
I thought it might be interesting to chart some of the data in Daniel’s report (page 6) for America’s largest cities. Interestingly the data suggests that, contrary to Daniel’s findings for Ohio cities, that the more educated a city is, the lower its credit rating (see chart above). Or put another way, the dumb cities are getting higher grades. Quelle surprise!
After posing this question on Twitter two responses stuck out:
@groditi Morally Bankrupt @cate_long maybe debt size? Do cities tend to borrow more as education levels rise?
@carney John Carney @cate_long I suspect that higher education level is also correlated with greater tolerance for debt, so more leveraged credit.
Political heat at S&P for ratings downgrades?
The Daily Show – What Are You Friggin’ Nuts Over There?
S&P replaces president after U.S. downgrade
The board of directors of McGraw-Hill met Monday and voted to oust Deven Sharma as president of their Standard & Poor’s rating division. This forced resignation comes approximately three weeks after S&P downgraded the debt of the United States. Jon Stewart, in the clip above, jokes about political pressure brought to bear on the company by the U.S. government. I think he is spot on with his humor.
Last week the U.S. Department of Justice just happened to discuss publicly an investigation of S&P and the other major raters about ratings assigned before the financial crisis to mortgage-backed securities, even though this investigation has been ongoing since 2009. Why the sudden need to reiterate this publicly? S&P’s downgrade was a brave action. It’s a pity that Deven Sharma has to pay for it with his job. As I wrote previously:
Standard & Poor’s took one of the bravest actions that I’ve ever seen a rater take when it downgraded the United States one notch. Furthermore, this marks a new beginning for accurate credit analysis and truth in fixed-income markets. Keep speaking the truth, S&P.
[...]
Bashing a rater for truth-telling is like punishing a child for speaking an unpleasant truth. It creates incentive to shade the truth, and the harsh truth is what is needed now more than ever.
Does a downgrade cost anything?
The debt of the United States was downgraded by Standard & Poor’s several weeks ago, but the price of U.S. Treasuries have skyrocketed since then. This confuses many people because a baseline relationship in the fixed-income markets is that lower-rated, less-creditworthy bonds will be relatively cheap and investors will demand higher interest rates to compensate for additional risk.
To see this bond market truism, it’s much more instructive to look at the downgrade of the debt of New Jersey. Fitch lowered the state’s credit rating Wednesday citing heavy debt and benefit obligations. This followed downgrades by Moody’s and S&P earlier in the year. Municipal bond and credit default swap markets didn’t like this third downgrade and did what you would expect them to do: they required more yield in the case of cash bonds and more payment in the case of credit default swaps.
The graph above charts muni CDS prices for New Jersey (data supplied by Markit). You can see the move up in CDS prices began in June when Governor Christie and the state legislature made the final run to their agreement on the fiscal 2011 budget, which began on July 1. The uncertainty and contentiousness of the process must have spooked investors and dealers.
The most widely-used measure of credit risk for municipal bonds is the Thomson Reuters Municipal Market Data (MMD) AAA GO Scale. MMD’s Daniel Berger in his daily note talks about how New Jersey bonds got riskier and cheaper ahead of the downgrade and suggests that cash-bond selling started happening ahead of the Fitch downgrade.
New Jersey has approximately $31 bln of appropriation backed-debt and $2.6 bln in GO [general obligation] debt. The spread of New Jersey’s 10yr GO bonds has steadily risen this past week and closed last night at +47bps to MMD’s AAA GO scale. Last Friday this spread was +40bps.
It looks as if traders were anticipating this move by Fitch and this confirms our thesis that spreads are a leading indicator of credit. For the latest 12-month period this spread averaged +56.3bps which ranks sixth highest among the states actively monitored by MMD.
The MMD chart perfectly shows how traders and investors responded to rating downgrades and how they demanded higher interest rates starting September 22, 1010. This was the date that Moody’s put New Jersey on “negative outlook,” the advance notice of a possible downgrade. The long, flat, tabletop-like area is the period of market confusion following Meredith Whitney’s pronouncement of default doom. Markets settled down after that with a decline in New Jersey’s risk profile before turning up again ahead of Fitch’s downgrade.
Fitch gives USA its stamp of approval
Fitch leaves munis tied to U.S. rating at AAA, S&P downgrades
Fitch Ratings, one of the three major rating agencies and the one considered the most accurate by institutional investors, has affirmed the credit rating of the debt of the United States at AAA. As a follow-on to this action they have also maintained the AAA credit rating of municipal entities tied to U.S. Treasuries.
Going in the opposite direction, Standard & Poor’s downgraded the investment portfolio of the city of Los Angeles to AA+ because it holds 80% of its assets in U.S. Treasuries. This follows S&P’s recent downgrade of U.S. Treasuries to AA+. The Bond Buyer reports what happened next:
Los Angeles has dropped Standard & Poor’s from rating its $7 billion investment portfolio after the agency downgraded it along with the United States last week.
“Quite frankly, we just don’t want to be associated with [Standard & Poor’s] anymore based on that decision. We think it was irresponsible and just excessive,” Thomas Juarez, the city’s chief investment officer and assistant treasurer, told The Bond Buyer.
S&P gave an honest opinion and is getting cut out of business. That is how the “paid for opinion” business works. If the entity paying for the rating doesn’t like it, then they don’t pay.
Rhode Island enhances financial disclosure for bond offerings
The Providence Journal reports that the Securities and Exchange Commission has been scrutinizing the state of Rhode Island about their financial disclosures associated with new municipal-bond offerings. As a consequence the state has expanded the level of detail that they are disclosing in their bond-offering documents. This increased transparency is critical for muniland. From the Providence Journal:
The swirl of ratings and CDS
The Wall Street Journal ran an odd article yesterday about the unpredictability of sovereign credit ratings that are below the investment-grade cutoff (BB+ and lower). Check out the table from the IMF of S&P’s sovereign ratings.
The WSJ article seemed to air some highly paid bond-fund managers’ whining that ratings were not a useful signal for when they should buy and sell bonds of specific countries. The complaint was also that ratings don’t include certain data sets that are important, such as fund flows in banks, and that they don’t have the agility of credit default swaps.
The guys quoted in the WSJ might be right on the data sets that raters use and they are certainly right about CDS being more agile than ratings. But ratings are not intended to mirror market sentiment like CDS does. They are supposed to stand above market panics and routs and give a 30,000 foot view of an issuer’s credit condition.
Raters should incorporate every type of information available to them. Markets want hot, accurate information. Raters create reputations for themselves for good analysis, and reputations rise and fall on good predictive ability. Information is money, and markets want to make money.
It’s a well known phenomenon in fixed-income markets that once a bond falls into the junk or speculative category that its rating becomes murkier for predicting default. So maybe credit ratings are more useful for investment-grade bonds and CDS are more useful for junk-grade securities? If there are any academic studies on the subject that you know of, please add them in the comments.
An interesting thing about muniland is that all states are rated investment grade. California has the lowest rating for a state at A-. See it on the last line in the great chart above from Stateline. S&P has adjusted California’s rating 7 times in the last ten years, which is pretty active for rating change on a major issuer. But the CDS on California is moving every day!
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Resident Muniland expert
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After this blog post appeared Bob Nelson tweeted out:
@cate_long investors just know them better – better disclosure. #muniland
To be continued…