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Ratings Rise for Munis A number of ratings agencies recently moved to a uniform ratings scale for all bonds. In the past, most ratings agencies have used a separate, and more stringent, set of standards for rating municipal bonds than corporate bonds. As ratings agencies employ this uniform standard, investors can expect to see a rise in the ratings of thousands of municipal bonds. Investors should not take this to mean these bonds have been deemed to carry reduced credit risk. Rather, the improved rating reflects a method of evaluating risk that is in keeping with the calibration used for corporate bonds. |
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If you have ever loaned money to someone, chances are you gave some thought to the likelihood of being repaid. Some loans are riskier than others. The same is true when you invest in bonds. You are taking a risk that the issuer's promise to repay principal and pay interest on the agreed upon dates and terms will be upheld. U.S. Treasury securities (for example, a Treasury bond, bill or note) and other bonds backed by the "full faith and credit of the U.S. government," are generally deemed to be risk-free. However, most bonds face a possibility of default. This means that the bond obligor will either be late paying creditors (including you, as a bondholder), pay a negotiated reduced amount or, in worst-case scenarios, be unable to pay at all.
Ratings are a way of assessing default and credit risk. The Securities and Exchange Commission (SEC) has designated 10 rating agencies as Nationally Recognized Statistical Rating Organizations (NRSROs). They are AM Best; DBRS Ltd.; Egan-Jones Rating Company; Fitch Ratings (Fitch); Japan Credit Rating Agency, Ltd.; LACE Financial Corp.; Moody's Investors Service (Moody's); Rating and Investment Information, Inc. (R&I); Realpoint LLC, which focuses on commercial mortgage-backed securities; and Standard & Poor's (S&P). These organizations review information about selected issuers, especially financial information, such as the issuer's financial statements, and assign a rating to an issuer's bonds—from AAA (or Aaa) to D (or no rating).
Each NRSRO uses its own ratings definitions and employs its own criteria for rating a given security. It is entirely possible for the same bond to receive a rating that differs, sometimes substantially, from one ratings agency to the next. While it is a good idea to compare a bond's rating across the various NRSROs, not all bonds are rated by every agency, and some bonds are not rated at all.
Not Perfect
Rating agencies don't always get it right. Enron was rated investment grade by the NRSROs just days before bankruptcy, and WorldCom was rated investment grade only three months before filing for bankruptcy. More recently, the collapse of the subprime mortgage market uncovered weaknesses in the ratings of many residential mortgage-backed securities that were linked to subprime mortgages.
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