Changing ratings game

November 14, 2008
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An institutional bond investor has asked a major ratings agency to adopt a single ratings system for all bonds. Doing so would benefit cities, counties and states. Bond buyers would figure to benefit, too.

Citigroup Global Markets Inc. has urged Moody’s Investor Services to rate tax-exempt municipal securities on “an even footing” with taxable and corporate bonds, which would change the market significantly.

The nation’s bond market has been historically divided into municipal and corporate, or tax-exempt and taxable, because each traditionally has had its own group of buyers and the ratings scale for each emphasized a different financial factor — such as the financial strength of the issuer for municipal and the risk of default for corporate.

But Citi contends the securities market has become more complex, and that complexity has led to a more integrated market. A more integrated market, in turn, means bond buyers aren’t as divided into two camps as they once were, and “municipal ratings can no longer be cloistered,” said Ward Marsh, Citi’s head of its municipal securities division.

City Debt and Authority Finance Officer Jana Wallace agrees.

“People want to diversify their investments and people will now buy both. Sometimes people need a tax-exempt security,” said Wallace, who indicated other investment groups were making the same request Citi has made.

While corporate bonds provide investors with a higher return because of more risk, the municipal version offers more security and tax-exempt income. But munis, as municipal bonds are known, normally must offer a higher interest rate to buyers than corporate bonds.

So the ratings agencies, like Moody’s, have used a different ratings scale for each type.

Corporate bonds, though, have historically defaulted more frequently than municipal securities. And the worldwide financial crisis has had investors scurrying for more secure offerings, as evidenced by the recent rush for U.S. Treasury bills, and they now want a more uniform and simpler method in place to be able to rate and analyze their purchases.

“What people are saying now is, look, you’re using two different criteria and you used to do that because two different groups of people would buy these bonds. But now all the markets are interconnected. We see that with the marketplace now,” said Wallace.

“Rather than having these two different scales and having the new investor and other investors having to remember that a double-A municipal bond is really a triple-A corporate, why not just use the same criteria for everybody and come up with a global ratings scale? That’s what they’re proposing,” she said.

Here is the payoff: If the ratings agencies make that switch to a single scale, most cities, counties and states will pay a lower interest rate when their long-term new and refunding securities go to market.

The current method rates bonds from municipalities lower than the corporate securities so the public sector pays more interest to buyers, even though municipal bonds have lower risk and are less likely to go into default.

“Because these ratings have been lower than corporate ratings, we have to pay higher interest rates than we would if we were judged on the same scale as corporate. That’s the problem with these double, different ratings,” said Wallace.

“What Citigroup is saying is: There was a difference, but there isn’t much of a difference anymore, and you guys need to recognize that.”

Another glaring change in the bond market is almost all insurers have been downgraded by the ratings agencies. In the past, a municipality with a double-A rating could get a triple-A mark by paying to have its offering insured. But today, Wallace said, most buyers are looking for a “natural” rating and not an insured one due to the declining financial standing of the insurers.

“If you look at our bond issues over the last few years, for the most part we were buying the insurance that gave us a triple-A,” she said. “Now, you’re actually better off not buying the insurance, usually, because most of the insurance firms don’t have triple-As.

“Now what ratings agencies and bond buyers are looking for are good, natural ratings rather than an insured rating.”

Wallace said when the city considers issuing bonds, they still ask underwriters to come up with cost-benefit scenarios that include one with insurance and one without. But she added the city doesn’t expect that an analysis with insurance will provide a better benefit than one that doesn’t include that cost, based on the current state of insurers and the natural rating that buyers want.

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