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Written by: Len Reininger | Advisor Asset Management
Over the past several months, you might have noticed a higher degree of municipal rating changes than usual. All three major rating agencies have adjusted their methodologies, making changes to ratings without any obvious catalyst triggering the rating change. This is due to the methodology changes detailed below.
Moody’s
Moody’s placed the ratings of 225 special tax instruments on review for possible upgrade and 11 on review for possible downgrade in conjunction with the release of its new ratings methodologies. This included new notching guidance for assigning ratings to special tax instruments that are closely related to the government’s issuer rating. Essentially, if the special taxes are broad-based, the pledged taxes are essential to government operations, the bonds secured by the special taxes were issued for essential purposes, and/or debt service coverage is strong, the ratings will either be brought in line with the issuer rating or notched off by a certain amount depending on a combination of these factors (essentiality, debt service coverage, etc.). Some of these taxes may include sales taxes, motor vehicle related taxes, tourist development taxes, or any other special tax. While the rating on these taxes will be changed, the ratings of the related government that the taxes are tied to will remain as is.
Standard & Poor’s (S&P)
S&P may also be changing up to 436 municipal ratings due to a change in its methodology. The existing ratings for the impacted municipals will be designated as ratings “Placed Under Criteria Observation” that will be found in the company’s individual pages on its website. Essentially, S&P is consolidating the multiple criteria to analyze credit risks of U.S. governments using one comprehensive scored framework instead. In other words, the same criteria (i.e., fund balance, financial performance, debt burden, etc.) will be used across all types of municipal governments regardless of whether it is a school district, college district, or a general obligation of a city. This will, per S&P, bring government entities under the same analytic framework, increase the transparency of the methodology, improve consistency and alignment of ratings across these government types, and enhance global comparability.
For schools and special districts, expected changes are primarily due to the movement to scored criteria from non-scored (factors that were not included in a model but were included for other local governments now will be included) and the adoption of a methodology that assesses a common set of weights and factors across all U.S. governments. For counties and municipalities, expected changes are primarily due to changes in the factor weightings, with less emphasis on economic factors and more emphasis on debt and liabilities than in the former criteria.
Finally, S&P will be placing a greater emphasis on what it calls an “institutional framework,” which is more of a qualitative assessment of the entity’s operating environment and practices, such as historical track records, predictability, revenue and expenditure balance, and transparency and accountability, among others. Rating changes, whether upgrades or downgrades, are not expected to exceed one notch. S&P summarizes the rating changes as follows:
- For U.S. states and territories, all ratings will remain unchanged.
- Approximately 2% of county ratings could change, generally by one notch higher or lower.
- For municipality ratings, approximately 4% could change, generally by one notch higher or lower.
- About 5% of school district ratings could change, generally by one notch higher or lower.
- For special district ratings, approximately 5% could change, generally by one notch higher or lower.
Fitch
Fitch is implementing the most impactful criteria changes that will affecting 35% of its municipal ratings. Essentially, the rating agency is de-emphasizing debt burden (overlapping debt) and putting a much greater emphasis on demographics, income levels and population trends. For example, if the 10-year population trend is negative, that will have a much larger impact than before. Additionally, median household income and educational attainment (percent of population with a bachelor's degree or higher) will play much larger roles.
Lastly, Fitch will look much more favorably on municipalities with population and local economy of “sufficient size and diversification”. In other words, if the city/county is the economic anchor of the region with a large population and economy, that is a big positive. You are out of luck if the municipality is of small size without much of an economic impact. Another factor that will receive greater emphasis is the degree of revenue control the government has (might be more qualitative in nature). Additionally, revenue volatility will be measured through economic cycles, along with the lowest three-year revenue performance.
Fitch will also be calculating an economic concentration index (the sum of the absolute deviation of the percentage of personal income by major economic sectors relative to the U.S. distribution) which may hurt small issuers the most. Traditional factors such as financial reserves and pension burdens are not changing but will be weighted differently. All-in-all, the overall shift appears to be towards demographic and economic factors.
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