Aurora Borealis
28 February 2019 CFA Institute Journal Review

Credit Ratings and the Cost of Municipal Financing (Digest summary)

  1. Servaas Houben, CFA

Improved technology, a potential conflict of interest, and the information gap between credit ratings and underlying fundamentals may have reduced the usefulness of credit ratings to practitioners. But the authors find that aside from regulatory reliance, credit ratings remain relevant for investors and issuers. Furthermore, the economic impact of ratings is significant.

How Is This Research Useful to Practitioners?

The authors assess whether rating agencies are still important channels of information on credit risk between companies and investors. Exploring this issue is challenging because it is often unclear whether (1) investors’ views are based on the ratings of the rating agencies or (2) investors’ and rating agencies’ views are both based on the underlying fundamentals. The global financial crisis harmed the reputation of rating agencies. Nevertheless, in markets with mainly regulated investors (e.g., insurance companies), ratings remain very important.

The authors analyze the effect of a change in Moody’s Investors Service criteria for the municipal bond market. Regulated investors are active mainly in the corporate bond market, which is sensitive to regulatory implications of ratings. Unregulated retail investors control the municipal bond market, and changes in regulations (methodology) have less effect on this category of investors. Focusing on the municipal bond market allows the authors to isolate the effect of a change in rating and the effect this has on yields and spreads.

In the spring of 2010, Moody’s changed its criteria from estimating the likelihood of government financial support to estimating expected loss, in line with other asset classes. As a result, some municipal bonds were upgraded. The authors conclude that investors responded to these upgrades, which resulted in a decrease in credit spreads.

To test the robustness of their results, the authors investigate whether liquidity increases with credit quality and find it does not. They also explore whether (1) the timing of the new criteria affects the results or (2) a change in fundamentals between upgraded and non-upgraded bonds might explain the change in credit risk; they find neither of these to be true. They therefore conclude that investors still use ratings to assess credit risk, especially in environments with little other information.

Thereafter, the authors determine the economic impact of ratings by using a multivariate difference-in-differences approach. They conclude that the economic impact is meaningful and has resulted in lower municipal borrowing costs.

Because ratings are a valuable credit risk information source, this research should be very interesting for a broad range of financial professionals. For professionals involved in municipal borrowing, this research shows the impact and relevance of ratings.

How Did the Authors Conduct This Research?

The authors use the Moody’s and Standard & Poor’s bond market prices, transaction volumes from the Municipal Securities Rulemaking Board, and Ipreo issue/issuer characteristics. Moody’s reported in 2008 its intention to change the municipal bond rating assessment, and recalibration took place on four dates in the spring of 2010.

First, the authors analyze the effect of the recalibration and show that some bonds were upgraded while others were not. They then show that the recalibration had a permanent effect and that most upgrades remained valid in the subsequent year. They also show that the new calibration approach is applicable for new issues.

Next, they use secondary market information to focus on retail investors, filtering by trade size. They also gather after-tax yield data of US Treasuries because municipal bonds are usually tax exempt.

The authors then assess the impact of the change in methodology on cumulative abnormal returns, which turns out to be positive for upgraded bonds. They perform univariate tests and conclude that increases in returns for upgraded bonds happened during the calibration dates. They apply multivariate difference-in-differences tests with yields and credit spreads as dependent variables and conclude that the effect of recalibration on yields is greatest for bonds with larger upgrades. Thereafter, they test whether the differences in returns existed before the recalibration but find that the market reacted to this unique event. They also explore whether increases in liquidity, shifts in demands for certain government bonds, or changes in fundamentals in bonds might explain the results but find that these factors do not.

Finally, using a difference-in-differences approach, the authors assess the economic effect of credit ratings and conclude that the impact of ratings is economically meaningful. They also determine that ratings provide the most information in weak information environments. They show that support for regulation-based demand is limited.

Abstractor’s Viewpoint

Ratings are a central input in risk management and regulatory capital assessment for institutional investors and thus affect many financial professionals. The authors assess the economic impact of ratings as well as ratings’ relevance for investors, making their research very interesting. They apply several techniques and test several hypotheses to reach their conclusions; their research represents a very thorough analysis of ratings relevance. The article is well written and easy to access, and the buildup is sensible, covering the relevance of ratings first and then their economic impact. The authors provide valuable historical context, which helps the reader understand why a critical view on ratings is necessary.

Overall, the research provides a very convincing case for the relevance of ratings for both investors and issuers.

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