If they are correct in their conclusions, it might pay for some advisors and investors to re-evaluate the risks involved in investing in municipal bonds.
The three authors of the report, Jess Cornaggia of Indiana University, Bloomington, Kimberly Rodgers Cornaggia of American University and John Hund of Rice University, said the study focused on Moody’s track record, but the close similarity in ratings among the three raters suggest their methodologies share similar shortcomings.
Interviewed by On Wall Street, Jess Cornaggia, an assistant professor of finance at Indiana University’s Kelly School of Business, said, “Contrary to what the Big-Three raters have been saying for years, credit ratings are not comparable across asset classes.”
He said that as a result, sovereign issuers have been “shafted,” that municipal issuers have been treated “harshly” and that corporate issuers have been evaluated more strictly than structured products.
This variation in the way ratings are handled, he asserts, bears an inverse relationship to the amount of revenue that the rating agencies derive from those same asset classes.
As the authors put it in their report, “Consistent with a conflict of interest in an issuer-pays compensation structure, ratings standards are inversely correlated with revenue generation among the asset classes.”
The significance of this finding for investors and for their advisors, Cornaggia suggests, is that people who are looking for relatively low-risk returns may be accepting lower yields than they need to for the risk level they are seeking.
For example, he explained, an advisor might recommend an A-rated muni bond or muni-fund for an investor who wants the security of an A-rated corporate issue, when a B-rated muni might be just as secure as that corporate A rating in terms of default risk. Yet the B-rated muni would have offered a significantly higher yield than the A-rated muni.
“While it could be done, it would be a fair amount of work for the advisor or individual investor to figure this out by looking into the default rates for the different muni ratings,” he said.
Albert Metz, managing director for credit policy research at Moody’s, scoffed the report’s conclusions, saying that Moody’s has always been “very public in saying that munis were rated on a different scale” than corporates.
He told On Wall Street that “to ‘discern’ this in a report is hardly new.”
Metz also argued that the report’s findings were distorted by the period of the financial crisis, when a high percentage of structured product debt went belly up.
“All their analysis is built on the drop in U.S. housing prices after 2007,” he said. “And structured product ratings linked to housing obviously underperformed. That’s not news either.”
Arguing against the idea that the compensation system used by the big three rating firms -- in which issuers being rated pay for the ratings of their bonds -- might influence those ratings, Metz noted that Moody’s changed its own compensation system around 1970 from an investor-pay to issuer-pay model, “and looking at the two eras, ratings accuracy is much higher now than before.”
Cornaggia counters that even within the structured product asset class, his report found that those categories of issues that provided more revenue to the rater fared better than those issues that brought in less revenue.
The report is likely to spark a debate for some time and could be aired before the Securities and Exchange Commission and in Congress down the road.
In the meantime, though, advisors and investors who are looking into municipal bonds and municipal bond funds for income in a portfolio may want to look deeper into those ratings to consider just how great the risks of default really is.