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Fixed-Income Insights

The increased frequency of changes to ratings methodology can cause confusion—and volatility—in the municipal bond market.

In the first half of 2018, there were more municipal bond upgrades than downgrades from the three major U.S. rating agencies: S&P Global, Moody’s, and Fitch. Upgrades of muni debt have outstripped downgrades in every year since 2015, although there have been quarters where individual rating agencies issued more muni downgrades than upgrades. Although the broader trend can be viewed as suggestive of an improving U.S. credit environment, there is actually an additional factor at work.

The frequency of rating actions being triggered by methodology or criteria changes by the three agencies has been increasing, with the resulting rating changes often having little to do with underlying credit. In the second quarter of 2018, for example, S&P increased the ratings of 324 issuers while downgrading 204. However, excluding changes due to criteria revisions, there would have been 186 upgrades and 177 downgrades. It is important to emphasize that even though many upgrades have come because of the criteria changes, upgrades continue to outpace downgrades where criteria changes are not a factor, indicating that credit quality continues to remain strong in the municipal bond market.

What’s behind the stepped-up pace of methodology changes? In the wake of the Great Recession, Congress set its sights on imposing stricter regulation on the financial markets, including the rating agencies, by passing the Dodd-Frank Act in 2010. A provision of Dodd-Frank that resulted in rating volatility was the rule that required the rating agencies to be more transparent, compelling them to update their sector criteria annually. Prior to the recession, the rating agencies rarely revisited their sector criteria, and when they did, the revisions were fairly minor. The rating agencies are using the annual review timetable as an opportunity to make significant changes to their methodology, resulting in numerous rating changes that have little to do with the credit quality of the individual issuers.

Split Decisions
Such criteria changes can have far-reaching effects. When S&P released revised criteria for rating priority-lien tax revenue bonds on October 22, 2018, the agency projected that, after a review of the 1,300 ratings it maintained for this type of debt, 15%-25% of ratings would not change while 40%-50% of ratings would rise or fall by one notch, 15%-25% by two notches, and 10%-20% by three or more notches. Although the rating agencies give advance notice of the criteria change and encourage comments from investors, they provide little guidance as to which credits will be affected and the specific magnitude of the rating changes. This leaves investors guessing as to the potential impact on issuers and often catches the market off-guard when multi-notch upgrades or downgrades are announced.

With each of the rating agencies developing its own criteria for each sector, and then revising the criteria annually, it is not surprising that split ratings (different ratings for the same issuer) are becoming more common—and that the divergence can be significant for certain issuers. According to data from Municipal Market Advisors (MMA), 40% of municipalities that have ratings from different agencies have a split rating. Although rating agencies will say that providing investors with a range of opinions is a good thing, the potential variance does underscore the fact that ratings have a subjective element.

Special tax bonds are a particular sector that has caused much debate and confusion among the rating agencies and investors. These are bonds that are secured by dedicated revenues generated within a municipality or state, such as sales taxes. The rating agencies historically would provide high ratings on these securities if the debt service coverage from the special revenues was strong, even if the credit quality of the related city or state was weak. The rating agencies took comfort in the fact that the revenue pledge protected investors from the city or state using the revenues for their own operations.

However, there have been recent examples involving distressed municipal issuers, such as Detroit and Puerto Rico, where the special tax protections have been challenged and the special tax bondholders have been impaired, even though the special tax revenues remain strong. Since then, the rating agencies have changed their approach in different ways, but S&P and Fitch in most cases will still rate special tax bonds higher than the related general obligation (GO) bonds, if the related GO credit quality is strong.

Single Opinions
This has incentivized cities and states with weak GO ratings such as Chicago and Illinois to carve out revenues that were used to support general governmental operations, such as sales tax, and pledge them to a new securitized sales tax bond. In that manner, the city is able to issue bonds with lower interest rates, as the special tax bonds will obtain higher ratings than their GO bonds. However, the city will have less revenue to fund operations, now that sales taxes are pledged to a new set of bonds. Further, the rating agencies have demonstrated in recent times that if the related GO is distressed, then they will downgrade the special tax bond significantly to match the rating of the GO—often without warning—leaving investors with bonds that are worth far less than what they purchased them for. With Moody’s now capping the rating of special tax bonds to the GO rating of the related issuer, there are many instances where its ratings are much lower than those of S&P and Fitch.

One consequence of the rating divergence is the fact that there are now more bonds that are rated by a single issuer. In a June 14 Bond Buyer article,1 it was reported that single rating transactions represent 25% of new sales by par value so far this year, as compared to 21% in all of 2017 and 13.4% in 2007. Many investors believe that issuers are “shopping” for the best ratings. Although some market observers suspect that this practice has always been in place, it is likely more prevalent now that ratings for the same issuer can be significantly different.

Most large asset managers, including Lord Abbett, have enhanced their research capabilities post-recession by hiring more analysts to conduct independent credit research.  At the same time, ratings still do influence pricing. Therefore, it is critical that analysts put much effort into understanding the criteria and the methodology employed by the rating agencies to stay ahead of potential rating changes, a task that has become more challenging given the pace, and frequency, of the  agencies’ alterations to their criteria.

 

1Christine Albano, “Rise in Single-Rated Municipal Bonds Spurs Investor Concerns,” The Bond Buyer, June 12, 2018.

 

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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