Can investors trust credit ratings on muni bonds?

(MoneyWatch) My recent post on state pension obligations brought questions about the value of the ratings provided by such agencies as Moody's (MCO), Standard & Poor's and Fitch. While it's true that the ratings agencies lost a lot of credibility for their failure to correctly analyze the risks of a wide range of asset-backed securities (ABS) in the years leading up to the financial crisis, such as collateralized debt obligations and mortgage-backed securities), municipals are a horse of a different color.

It's important to understand that the ratings agencies had a major conflict of interest in rating ABS. The conflict arises from the fact that the higher the credit rating the agencies provided, the more of these securities the issuers could originate. And the more securities issuers originated, the greater the fees the agencies could earn.

With municipal bonds the story is very different. A school district isn't going to build another school simply because they received a higher rating than they should have. A municipality isn't going to build another sewer system because of higher ratings. And a state isn't likely to build more highways just because of higher ratings. So inflated ratings don't lead to more fees for the raters of the bonds. The same conflict of interest doesn't exist.

To demonstrate that the ratings on municipal bonds have been extremely accurate we can look at the historical evidence. The following are a few key data points from a recent report by Moody's Investor Services that covers the period 1970-2011.

• For general obligation bonds (GOs) the one-year persistence of ratings for AAA-rated bonds was 98 percent. For AA- and A-rated bonds the persistence figures (maintaining the credit rating or being upgraded) were 99 percent and almost 100 percent, respectively.
• The 10-year cumulative default rate on AAA-rated bonds was 0 percent. For AA- and A-rated bonds the respective figures were just 0.01 percent in both cases.
• The 10-year cumulative default rate on AAA-rated non-GO bonds was also 0 percent. For AA- and A-rated non-GOs the respective figures were just 0.03 and 0.09 percent. However, the next three lower ratings (Baa, Ba, and B) experienced default rates of 0.8 percent, 6.4 percent and 29.2 percent. All investment-grade non-GOs had a default rate of 0.2 percent, versus the 12 percent default rate on speculative non-GOs.

The data makes clear that in the absence of the conflict of interests inherent in the asset-backed securities world, the ratings agencies have done an outstanding job of properly assessing the risks of investing in municipal bonds.

That said, when buying municipal bonds it's important to note that investors should be careful to not rely solely on the credit rating as an indicator of the riskiness of a bond. The reason is that the ratings agencies are generally slower than the market in adopting ratings to current conditions. Thus, if you're offered an A-rated bond that carries the higher yield of a Baa-rated bond, you shouldn't think that you're getting a bargain. It's far more likely that the market is ahead of the rating agencies in assessing risks, and that you're buying a bond that is subject to more risk than typical A-rated bonds, and is more likely to be downgraded in the future.

So if your credit standards require at least an A-rating, you should avoid buying this particular bond.

Image courtesy of Flickr user Tax Credits