Muni Bonds: Moody's Maps Muni Ratings To Corporate Bond Ratings

Moody’s Default Report

Last month, Moody’s issued a report entitled: “The U.S. Municipal Bond Rating Scale: Mapping to the Global Rating Scale and Assigning Global Scale Ratings to Municipal Obligations.” The purpose of the report is to map muni ratings to the corporate rating system.

We have felt that one of the in-efficiencies in the taxable bond market is taxable muni bonds trade too cheaply for their quality. Recent experience shows that a Aaa-rated taxable muni trades at about the same spread to U.S. Treasuries as an A-rated corporate bond. This makes no sense, because the munis are less likely to default and are not subject to the same event risk as a corporate bond. This report confirms our position on taxable munis. Moody’s shows default rates for the last 36 years on all bonds they rate. During this time period, there were a total of 41 defaults by municipal issuers considered to be investment grade (Baa or higher). Of these, only 1 default was backed by either a General Obligation pledge or Water & Sewer Revenues. These types of bonds have a very low risk of default. The chart below shows that an investment grade corporate bond has a 2.1% chance of defaulting during the next 10 years, while an investment grade muni has only a .1% chance of default, according to the study.

Moody’s separates munis into different categories and then maps them to corporate ratings.

Here are some of their conclusions:
1. An A-1 rated state GO is equivalent to a Aaa-rated Corporate Bond.
2. A Baa-2 rated local GO is equivalent to a Aa-3 rated Corporate Bond.
3. A Aaa-rated Corporate Bond is 5 times more likely to default during the next 10 years as an investment grade muni bond.
4. The risk of default by a State GO, local GO, or Water & Sewer revenue bond is much lower than other categories of muni bonds.
5. Local lease obligations and special tax, electric & gas for transmission, mass transit, public higher education, general airport revenues, and existing toll roads have all shown superior risk profiles.

Conclusions

There is less credit risk in certain types of muni bonds than the ratings imply because of their superior risk profiles. Moody's recognizes in this report that State and local GO's may be under-rated by their existing rating system compared to their Global Ratings for Corporate Bonds. Some Muni investors may wish to buy lower rated investment grade GO's and Water & Sewer bonds if they are over-compensated for the additional credit risk taken. Moody's estimates that about 50% of the Muni bonds they currently rate as Baa will be upgraded to A-rated in the near future. This may create opportunities for "spread tightening" trades. Unfortunately, credit spreads in the Muni market are currently relatively tight by historical standards. So, it may be difficult to take advantage of these potential upgrades by Moody's. The better opportunity for spread tightening may be in the Taxable Muni market where quality spreads still have plenty of room to compress.