On June 15, 2015, an SEC rule will go into effect requiring rating agencies to adopt procedures to weigh credit default risk in a consistent manner for all related obligors and securities. This means that private sector corporate issuers and municipal governments will be rated according to the same criteria. Some municipal market participants believe that historically, relative to corporate bonds, municipal ratings have been too low, exaggerating the risk of default. These participants predict that the new rule will therefore result in an upward trend in municipal bond ratings. This view however is not universal.
The SEC adopted the final rule (Rule 2014-178) regarding Nationally Recognized Statistical Rating Organizations (“NRSROs”) on August 27, 2014, with staggered implementation dates for various provisions. The rule is designed to implement Section 938(a) of the Dodd-Frank Act (the “Act”), which requires that NRSROs (i) assess the risk of issuer default or failure to make payments in accordance with the terms of the security, (ii) clearly define and disclose the meaning of any symbol used, and (iii) consistently apply the symbol to all types of securities. The Act also requires the SEC to examine NRSROs annually and issue a report.
NRSROs, including Moody’s and S&P, have been preparing for the effective date for years by recalibrating and applying new criteria to municipal issuer ratings. A 2010 recalibration by Moody’s resulted in higher ratings (one notch in the Aa category, two notches in the A category, and three notches in the Baa category) for general obligation, public water, and sewer utility bonds. And, in 2013 and 2014 S&P introduced new local government rating criteria leading to an average increase in ratings of approximately one-tenth of a notch across all credits.
Pursuant to the current rating scale, BBB municipal bonds carry higher tax-exempt yields than taxable AAA corporate bonds even though, over a 10-year period, the default rate of municipal bonds is lower than that of corporate bonds. This has resulted in a perhaps unjustified increase in municipal borrowing costs.
However, the consistent application of rating criteria across the private and public sectors is not necessarily all good news. Many market participants and commentators note that municipal default statistics are based on historical information but that an increase in municipal defaults may be on the horizon. Further, these skeptics note that, despite adjustments made by Moody’s and S&P to boost ratings, municipal default rates, while still low, are rising.
Schiff Hardin’s Public Law Group is actively engaged in legal developments affecting the municipal market. We regularly advise municipal debt issuers, underwriters, placement agents and credit providers.