Can you trust muni credit ratings

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larryswedroe
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Can you trust muni credit ratings

Post by larryswedroe » Wed Sep 18, 2013 8:25 am

Obviously an important issue given the failure of the agencies in the MBS market. My view is that this is a very different story

http://www.cbsnews.com/8301-505123_162- ... uni-bonds/

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Re: Can you trust muni credit ratings

Post by rkhusky » Wed Sep 18, 2013 11:32 am

Are the ratings for corporate bonds comparable to the munis? A few years ago there was an effort to revamp the ratings to make them more equal, but I suspect that an A-rated muni is still safer than an A-rated corporate. In my AA calculations, I assume that munis are still ahead by one full grade.

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Re: Can you trust muni credit ratings

Post by TheGreyingDuke » Wed Sep 18, 2013 11:38 am

Why is it that the CBS site always "locks" my browser (Chrome), that is I cannot simply come back to bogleheads, frustrating when I forget to open it in a new tab!
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Re: Can you trust muni credit ratings

Post by gasman » Wed Sep 18, 2013 11:42 am

duplicate post deleted
Last edited by gasman on Wed Sep 18, 2013 11:48 am, edited 1 time in total.

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Re: Can you trust muni credit ratings

Post by gasman » Wed Sep 18, 2013 11:45 am

gasman wrote:Question for Larry,

Has there been the equivalaent of "grading on a curve" or "grade inflation" in the muni credit markets over the last decade or so?

E.g., are AAA, AA, ratings etc. assigned to whatever the top percentage of credit issuers is regardless how bad the group is as a whole?
Are accounting standards used by rating agencies for giving ratings and the standards used by municipalities for presenting their financial condition the same as they were historically such that a AA rating issued today is as meaningful as a AA issued twenty years ago?

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Re: Can you trust muni credit ratings

Post by Jack » Wed Sep 18, 2013 1:40 pm

Sorry, but the rating agencies have demonstrated that they are criminal enterprises who use bribery and extortion to increase their profits. Simply because they haven't yet demonstrated a way to do that with munis does not mean they aren't desperately trying to figure out new ways of doing that. People with criminal motives do not change their spots. They can never be trusted.

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Re: Can you trust muni credit ratings

Post by larryswedroe » Wed Sep 18, 2013 2:35 pm

jack
Skepticism is healthy, but excessive skepticism is not.
There were incentives for them to do the wrong thing with MBS and ABS in general, while there is no incentive in munis.
Best wishes
Larry

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Re: Can you trust muni credit ratings

Post by Van » Wed Sep 18, 2013 5:37 pm

Larry,

Thank you for bringing attention to your article on the accuracy of ratings for municipal bonds. As someone highly invested in municipal bond funds, it was very reassuring.

Van

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Re: Can you trust muni credit ratings

Post by Artsdoctor » Wed Sep 18, 2013 5:44 pm

Larry,

Thank you for the post. Morningstar just released their annual State of Pension Plans and the report was very sobering, as you've been discussing in the past. The decreased funding of pension plans will inevitably be challenging and I know it'll be taken into account more in future ratings. I've heard it said that most ratings will remain the same; there will be "a few" upgrades and "some" downgrades but not a lot of changes. Do you think the ratings agencies are being proactive enough in considering the pension fund "underfundings" at this point?

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Re: Can you trust muni credit ratings

Post by Jack » Wed Sep 18, 2013 6:40 pm

This is important stuff because it goes to how you look at the safety of your bond portfolio.

When Larry argues for the rating agencies' history of accuracy as evidence of confidence in the rating agencies I can only say that their history of accuracy for triple-A rated junk CDOs was perfect right up until the moment when it wasn't.

I think you would be better served by just listening to what the rating agencies say about their own ratings in internal emails.

1. From a company executive, "Lord help our f...ing scam. This has to be the stupidest place I have worked at."

They say they are running a scam and I believe them.

2. From an analyst, "we have just stuck our proverbial finger in the air!!"

3. Another analyst says “As you know, I had difficulties explaining ‘HOW’ we got to those numbers since there is no science behind it."

4. Another says “If we are just going to make it up in order to rate deals, then quantitative analysts are of precious little value."

5. And “Let’s hope we are all wealthy and retired by the time this house of cards falters."

6. Or this conversation between two officials
A: "By the way, that deal is ridiculous"
B: "I know, right. The model definitely doesn’t capture half the risk."
A: "We should not be rating it"
B: "We rate every deal. It could be structured by cows and we would rate it"

They say they would rate a deal even if it was structured by cows and I believe them.


Out of context you say? Then let's see what they say under oath in a court of law.

7. This is what S&P said in a press release as they crowed about the dismissal of a case against them.
"The Second Circuit affirmed the district court's dismissal of the plaintiffs' claims in their entirety, finding that the statements concerning the "integrity and credibility and the objectivity of S&P's credit ratings" were exactly "the type of mere 'puffery' that we have previously held not to be actionable."

If S&P themselves brags that S&Ps claims of integrity, credibility and objectivity are "mere puffery" then I believe them.


8. S&P themselves said "The Court found that "generalizations about [S&P's] business practices and integrity" were "so generalized that a reasonable investor would not depend on [those statements]"

So if S&P themselves argue that that S&P claims of integrity are so generalized that a reasonable investor would not depend on them, then as a reasonable investor, I agree, we should not depend on their integrity.


9. S&P themselves also said "Most of the plaintiffs were sophisticated institutional investors that did not actually rely on the ratings in making decisions," he wrote. These plaintiffs, he went on, were "large institutional investors with significant investment staffs of their own," and some of them, he pointed out, didn't cover themselves in glory with their background research.

In other words, they are saying you have only yourself to blame for trusting our ratings, so I don't trust them.

Larry says that we should just trust the bond ratings, but S&P themselves says, in court, that you would be a fool to do so.

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Re: Can you trust muni credit ratings

Post by larryswedroe » Wed Sep 18, 2013 7:57 pm

Jack
Like I said you have two very different situations with very different motivations. One set led to bad behavior. The conditions for that behavior don't exist in the muni market.
You can believe what you want and doing so will lead to a large sacrifice in returns, which IMO is a mistake.
FWiW-if anyone advises to stick with the safest bonds because of the role I believe bonds should play it's me.


Artsdoctor
The report I cited is evidence of how proactive the agencies are becoming in this area.
Best wishes
Larry

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Re: Can you trust muni credit ratings

Post by Jack » Thu Sep 19, 2013 11:27 am

larryswedroe wrote:Jack
Like I said you have two very different situations with very different motivations. One set led to bad behavior. The conditions for that behavior don't exist in the muni market.
We already know their motivations. They have demonstrated that their motivations are the same as other crooks, to enrich themselves in any way possible. Nothing has changed. No one has gone to jail. No fines were paid. No one missed a bonus. No one was fired. All the same crooked executives that ran the agencies are still there. The motivations aren't different. They are the same as they always were and if they can figure out a way to game the system they will.

This does not mean that one should not invest in bonds. It just means you should take no comfort in AAA ratings.

As S&P said in court, no reasonable investor should depend on the integrity of the rating agencies. As S&P themselves said in court, you would be a fool to trust their ratings.

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Re: Can you trust muni credit ratings

Post by afan » Thu Sep 19, 2013 11:51 am

I am afraid I have to join in the trashing of muni bond ratings. Of course, we have the remarkable claim by S&P that their ratings were meaningless, that everyone knew they were meaningless, that their claims of integrity were meaningless, and that essentially no one should pay any attention to anything they say.

But it is worse than that.

First, as to Larry's point that the ratings agencies, too dishonest to give reliable ratings when it was their interest to lie, can be trusted with muni ratings because they have no incentive to cheat. Well, municipal issuers look at the ratings they can get and the effects of more debt on their credit ratings just as commercial issuers do. Municipal issuers base the size of their borrowing in part on what sorts of ratings and interest rates they can get. They get better rates if they get higher ratings. They may not be able to make the huge profits of commercial issuers by selling baskets of junk at AAA ratings, but they certainly stand to profit from paying S&P for better ratings than their financial status would justify. And S&P has already sworn under oath that, given an appropriate bribe, they will award whatever rating an issuer wants.

But it is worse than that.

The muni market has long been plagued by issuers ignoring rules for updating their financial reports. Many issuers are years behind in revealing how they are doing, and hence the financial support for their bonds. The rating agencies have done nothing to address this problem, they don't bother to update ratings until issuers go into default or publicity about the financial problems of issuers forces them to recognize the credit downgrades. So even if the ratings agencies were honest, and they have told you that they are not, they would be in no position to provide a meaningful rating on most outstanding muni debt.

You can probably trust the market- not the ratings agencies, but the market- to analyze and price large issues of state general obligation bonds. So you might be able to trust FL vs CA vs IL vs NY based on market prices. For things other than state GO, you are on your own. The reward to buying some of this lower rated debt would have to be huge because you really have no clue as to what you are getting.

With the game largely up for the asset backed business, the ratings agencies might turn even more greedily to the muni market as a source of fees. If anything, I would be even less inclined to trust their ratings now than in the past.

And now they may feel innoculated against future claims of fraud by having announced that they are merely part of the marketing arm of issuers, and their claims about creditworthiness are meaningless.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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Re: Can you trust muni credit ratings

Post by larryswedroe » Thu Sep 19, 2013 12:19 pm

afan
So you believe municipalities will build more schools, more roads, more sewer systems because their rating is bit higher than it should be?
Note the evidence on 80+ years of ratings lines up extremely well in predicting returns
Also your comments on late filings etc are things the ratings agencies watch, though they are always lagging the market to some degree---which is why we don't rely SOLELY on ratings and won't even buy bonds in some sectors even if AAA rating because the persistence in those sectors are not high. We also subscribe to services that update immediately on the type of issues you raise about late filings and so on.
Having said that the ratings have reliably predicting defaults for many decades and I don't see any reason to think that they should change.
Best
Larry

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Re: Can you trust muni credit ratings

Post by larryswedroe » Thu Sep 19, 2013 12:19 pm

afan
So you believe municipalities will build more schools, more roads, more sewer systems because their rating is bit higher than it should be?
Note the evidence on 80+ years of ratings lines up extremely well in predicting returns
Also your comments on late filings etc are things the ratings agencies watch, though they are always lagging the market to some degree---which is why we don't rely SOLELY on ratings and won't even buy bonds in some sectors even if AAA rating because the persistence in those sectors are not high. We also subscribe to services that update immediately on the type of issues you raise about late filings and so on.
Having said that the ratings have reliably predicting defaults for many decades and I don't see any reason to think that they should change.
Best
Larry

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Re: Can you trust muni credit ratings

Post by jdb » Thu Sep 19, 2013 12:44 pm

Thanks Larry. Interesting article. I was not able to access the report you cited. You indicated that "All investment-grade non-GOs had a default rate of 0.2 percent, versus the 12 percent default rate on speculative non-GOs." Out of curiosity, what was the default rate for investment grade GO's?

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Re: Can you trust muni credit ratings

Post by larryswedroe » Thu Sep 19, 2013 2:58 pm

jdb, almost zero

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Re: Can you trust muni credit ratings

Post by Sidney » Thu Sep 19, 2013 3:44 pm

Jack wrote:This is important stuff because it goes to how you look at the safety of your bond portfolio.

When Larry argues for the rating agencies' history of accuracy as evidence of confidence in the rating agencies I can only say that their history of accuracy for triple-A rated junk CDOs was perfect right up until the moment when it wasn't.

I think you would be better served by just listening to what the rating agencies say about their own ratings in internal emails.

1. From a company executive, "Lord help our f...ing scam. This has to be the stupidest place I have worked at."

They say they are running a scam and I believe them.

2. From an analyst, "we have just stuck our proverbial finger in the air!!"

3. Another analyst says “As you know, I had difficulties explaining ‘HOW’ we got to those numbers since there is no science behind it."

4. Another says “If we are just going to make it up in order to rate deals, then quantitative analysts are of precious little value."

5. And “Let’s hope we are all wealthy and retired by the time this house of cards falters."

6. Or this conversation between two officials
A: "By the way, that deal is ridiculous"
B: "I know, right. The model definitely doesn’t capture half the risk."
A: "We should not be rating it"
B: "We rate every deal. It could be structured by cows and we would rate it"

They say they would rate a deal even if it was structured by cows and I believe them.


Out of context you say? Then let's see what they say under oath in a court of law.

7. This is what S&P said in a press release as they crowed about the dismissal of a case against them.
"The Second Circuit affirmed the district court's dismissal of the plaintiffs' claims in their entirety, finding that the statements concerning the "integrity and credibility and the objectivity of S&P's credit ratings" were exactly "the type of mere 'puffery' that we have previously held not to be actionable."

If S&P themselves brags that S&Ps claims of integrity, credibility and objectivity are "mere puffery" then I believe them.


8. S&P themselves said "The Court found that "generalizations about [S&P's] business practices and integrity" were "so generalized that a reasonable investor would not depend on [those statements]"

So if S&P themselves argue that that S&P claims of integrity are so generalized that a reasonable investor would not depend on them, then as a reasonable investor, I agree, we should not depend on their integrity.


9. S&P themselves also said "Most of the plaintiffs were sophisticated institutional investors that did not actually rely on the ratings in making decisions," he wrote. These plaintiffs, he went on, were "large institutional investors with significant investment staffs of their own," and some of them, he pointed out, didn't cover themselves in glory with their background research.

In other words, they are saying you have only yourself to blame for trusting our ratings, so I don't trust them.

Larry says that we should just trust the bond ratings, but S&P themselves says, in court, that you would be a fool to do so.
And they appear to be back at it.
http://dealbook.nytimes.com/2013/09/17/ ... eria/?_r=0
I always wanted to be a procrastinator.

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Re: Can you trust muni credit ratings

Post by Jack » Thu Sep 19, 2013 6:21 pm

Sidney wrote: And they appear to be back at it.
http://dealbook.nytimes.com/2013/09/17/ ... eria/?_r=0
As the article indicates, once again S&P has modified its formulas to pump up their ratings in order to win business.

S&P recently began an advertising campaign declaring that it “used the lessons learned from the financial crisis to improve the methodologies, procedures and rigor underlying our ratings.”

A think it is safe to say we can assume this statement is "mere puffery" and not intended to be truthful.

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Re: Can you trust muni credit ratings

Post by docneil88 » Fri Sep 20, 2013 1:11 am

From http://www.cbsnews.com/8301-505123_162- ... uni-bonds/ :
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.
A higher rating implies a lower cost of funding, which may allow the engineers to extend the highway a bit. To decrease the cost of funding, wouldn't municipalities have an incentive to choose a particular rating agency if it tends to give higher ratings than the other agencies. If so, wouldn't there be a corresponding incentive to those agencies to be the one that tends to give higher ratings than the others? Best, Neil

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Re: Can you trust muni credit ratings

Post by afan » Fri Sep 20, 2013 4:33 am

Municipalities spend what they can. If the cost of a school, sewage system, whatever, is too high, then they will scale back, delay, or not do it at all. Bond proposals get rejected by voters when they appear too expensive. Depending on what they can borrow, cities make retirement and health care promises to employees. So, yes, it is clear that bribing a credit rating agency to improve the rating, and lower the cost of capital, will lead issuers to borrow more money.

Ratings may distinguish investment grade from junk bonds, beyond that the data are not that supportive of the precision of the ratings. Plus, we are in a different market now than we were when the data were generated. Through most of that time there were municipal bond insurers. They would only insure high quality credit. Until the companies went crazy and started insuring everything, they cared about the quality of the issues they insured. Thus, for the top credit, there were entities independent of the rating agencies that made public their opinions of credit quality, and put their money behind these opinions. It turned out that muni defaults were so rare that the muni insurers got greedy and then went bankrupt, but for quite a long time it was a legitimate business.

Subscribing to services that notify you when a bond issuer files financial reports is great, but it only helps if the bond issuers actual file the reports. Many munis simply ignore these requirements and are years behind.

When a ratings agency swears in court that its ratings are meaningless, and that high ratings are for sale to anyone who pays the right price, it is hard to assume they behave otherwise.

This does not mean "don't buy munis", but it does mean "don't trust the ratings". People buying munis need to have analysis independent of the agencies. They can pay Vanguard a very small fee to do this, or they can do it themselves. There is no much payoff to buying individual issues once one has to do the analysis and deal with opaque pricing and markups.

But trust the ratings for munis when they have proven meaningless for commercial bonds? That seems irrational to me.
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Re: Can you trust muni credit ratings

Post by carolinaman » Fri Sep 20, 2013 6:44 am

Jack wrote:
larryswedroe wrote:Jack
Like I said you have two very different situations with very different motivations. One set led to bad behavior. The conditions for that behavior don't exist in the muni market.
We already know their motivations. They have demonstrated that their motivations are the same as other crooks, to enrich themselves in any way possible. Nothing has changed. No one has gone to jail. No fines were paid. No one missed a bonus. No one was fired. All the same crooked executives that ran the agencies are still there. The motivations aren't different. They are the same as they always were and if they can figure out a way to game the system they will.

This does not mean that one should not invest in bonds. It just means you should take no comfort in AAA ratings.

As S&P said in court, no reasonable investor should depend on the integrity of the rating agencies. As S&P themselves said in court, you would be a fool to trust their ratings.
I was a senior manager in a large urban county for more than 20 years. i was never directly involved in our interactions with rating agencies but was generally aware of the process. Our finance officer, county manager and commission chair would go to New York once a year to meet with rating agencies. It sounded to me as if it were a reasonably thorough process. They looked at our audited financial statements, revenues, debt, economic growth and issues that could affect our financial health. We had a AAA rating and feedback from the rating agencies greatly influenced fiscal strategy. The rating agencies seemed to have a critical eye towards our fiscal health and this was a really big deal for our govt officials.

Based upon how our county was handled, it gives me a lot more comfort to rely on muni ratings by rating agencies.

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Re: Can you trust muni credit ratings

Post by Sidney » Fri Sep 20, 2013 6:48 am

Jack wrote:
Sidney wrote: And they appear to be back at it.
http://dealbook.nytimes.com/2013/09/17/ ... eria/?_r=0
As the article indicates, once again S&P has modified its formulas to pump up their ratings in order to win business.

S&P recently began an advertising campaign declaring that it “used the lessons learned from the financial crisis to improve the methodologies, procedures and rigor underlying our ratings.”

A think it is safe to say we can assume this statement is "mere puffery" and not intended to be truthful.
The compensation model is flawed. The consumers of the ratings are the investors, not the issuers. If I were a large bond buyer I would create my own rating system internally (or partner with other buyers) rather than rely on the current agencies.
I always wanted to be a procrastinator.

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Re: Can you trust muni credit ratings

Post by rkhusky » Fri Sep 20, 2013 6:53 am

Are there not multiple credit rating agencies? Does that not create competition? I would think that large purchasers of bonds would go with the credit rating agency that has the best performance in predicting default rates.

If I am comparing two bond funds, how else can I judge their relative risk except by using the distribution of credit ratings?

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Re: Can you trust muni credit ratings

Post by nordsteve » Fri Sep 20, 2013 9:46 am

Public sector entities often gets rated by multiple entities. This is a meaningful check against ratings gaming that doesn't exist in the mortgage securities market.

That said, the existence of rating agencies doesn't absolve you from doing the legwork yourself. The ratings formula isn't rocket science.

For any unit of government:

1. What are the underlying demographic trends around population, incomes, and jobs?
2. How much debt is outstanding, both in the unit itself and in other units covering the same geography?
3. How conservatively are the finances managed? Does the unit of government cash flow? What reserves are carried? Is there a history of significant fund transfers? What is the history of the political leadership around capital investments?
4. What sort of revenue is being pledged, and what is the legal backing behind the pledge?
5. What feedback have the auditors had on the financial reports? Have the financial reports received any GFOA quality awards? Is there any history of not providing continuing disclosures?

I've been a long time observer of municipal finance in my state, and have had personal experience presenting to ratings agencies and seeing the results. The ratings given are highly correlated with my personal impression of the rated agency's finances along the dimensions listed above.

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Re: Can you trust muni credit ratings

Post by Jack » Fri Sep 20, 2013 10:50 am

rkhusky wrote:Are there not multiple credit rating agencies? Does that not create competition? I would think that large purchasers of bonds would go with the credit rating agency that has the best performance in predicting default rates.

If I am comparing two bond funds, how else can I judge their relative risk except by using the distribution of credit ratings?
You seem to have it backwards. Purchasers don't get to choose the rating agency. The issuers (borrowers) get to choose the rating agency. Like college students choosing classes, borrowers want to choose the teacher who gives the highest grades. So yes, there is competition among rating agencies. They each compete to give the highest credit ratings so they will be selected by the most issuers. If the rating agency isn't selected by the borrower, they make no money.

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Re: Can you trust muni credit ratings

Post by larryswedroe » Fri Sep 20, 2013 11:33 am

Afan
First, the ratings distinguish quite well at ALL levels in muni market with monotonic increases in defaults as credit ratings go down
Second, even in the great depression the default LOSSES of the highest grade bonds (the only kind we buy) were very close to zero. If you want a stress test that was pretty good one.
Third, a difference in ratings leads to a change in rates, let's say 1 or 2% higher rates--that will not cause a municipality to build or not build an extra school. The cost of the school or project is orders of magnitude greater than the difference in ratings. At any rate there is no evidence of this effect in the data
Best wishes
Larry

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Re: Can you trust muni credit ratings

Post by rkhusky » Fri Sep 20, 2013 12:43 pm

Jack wrote:
rkhusky wrote:Are there not multiple credit rating agencies? Does that not create competition? I would think that large purchasers of bonds would go with the credit rating agency that has the best performance in predicting default rates.

If I am comparing two bond funds, how else can I judge their relative risk except by using the distribution of credit ratings?
You seem to have it backwards. Purchasers don't get to choose the rating agency. The issuers (borrowers) get to choose the rating agency. Like college students choosing classes, borrowers want to choose the teacher who gives the highest grades. So yes, there is competition among rating agencies. They each compete to give the highest credit ratings so they will be selected by the most issuers. If the rating agency isn't selected by the borrower, they make no money.
I admit I don't know the details of how the credit agencies get paid, but found this statement on Vanguard's website about Total Bond Market, which leads me to believe that some bonds are analyzed by multiple agencies.
Vanguard managed taxable index bond funds, balanced funds, ETFs, and annuity portfolios; and Wellington Management Company managed bond funds, balanced funds and annuity portfolios: Credit-quality ratings for each issue are obtained from Barclays using ratings derived from Moody's Investors Service (Moody's), Fitch Ratings (Fitch), and Standard & Poor's (S&P). When ratings from all three agencies are available, the median rating is used. When ratings are available from two of the agencies, the lower rating is used. When one rating is available, that rating is used. Vanguard managed taxable non-index bond funds, municipal bond funds, balanced funds and annuity portfolios: Credit-quality ratings for each issue are obtained from Moody's and S&P, and the higher rating for each issue is used.
It seems like if one company is inflating their figures versus the others and that is demonstrated, then the buyers of the bonds would demand some other agency rate the bonds they buy. Eventually, poor performance would lead to loss of business for the rating agency.

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Re: Can you trust muni credit ratings

Post by Jack » Fri Sep 20, 2013 12:56 pm

rkhusky wrote:I admit I don't know the details of how the credit agencies get paid...
But it is critically important that you should know that the credit agencies are selected and paid by the issuers of the bonds. That is why the agencies are motivated to give high ratings. Otherwise they won't be selected and won't be paid.
rkhusky wrote:It seems like if one company is inflating their figures versus the others and that is demonstrated, then the buyers of the bonds would demand some other agency rate the bonds they buy. Eventually, poor performance would lead to loss of business for the rating agency.
This is the entire point. One company is not inflating their figures. They all are. And this is to be expected by simple economics. The agencies are competing to be selected by the issuer or they don't get paid. The way the get selected is by giving higher ratings. They are all competing to give the highest ratings. Competition in this case, since they are being selected and paid by the issuer, pushes towards higher ratings, not more accurate ones. Agencies are paid to give high ratings. They are in no way paid to give accurate ratings. The buyers of the bonds don't pay or select the agencies, the issuers do.

I realize that this is a difficult concept to grasp because it is so backwards and counter-intuitive but it really is the way it works. It is so crazy that it defies common sense, but that is the way it works and the way bankers have set it up.

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Re: Can you trust muni credit ratings

Post by nordsteve » Fri Sep 20, 2013 1:44 pm

Jack wrote:This is the entire point. One company is not inflating their figures. They all are.
We've heard more than once on the thread that there's data supporting a strong correlation between municipal bond ratings and the actual quality of the bonds being rated. Can you cite facts that support your contention that, in the municipal bond market, ratings agencies are inflating their ratings? All of the data needed to support your thesis is publicly available.

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Re: Can you trust muni credit ratings

Post by larryswedroe » Fri Sep 20, 2013 3:03 pm

to further demonstrate the point about reliability of muni ratings consider the following data on transitions of ratings (data from 1979)
So for AAA and this ALL munis, not the higher quality sectors we limit our holdings to --the figures would be even stronger for GOs and essential service revenue bonds
to AA 1.44%
to A 0.16%
to Baa 0.03%
to Ba 0.01%

For AA
0.46% percent became AAA
1.44% became A
0.04% became BAA and
0.01% became Ba

And unlike with ABS and even corporates, munis don't go from say AAA to CCC overnight, as the data shows---not one AAA or AA went below Ba-- they migrate very slowly over time. Thus you have plenty of time to get out if you see a downgrade to level not comfortable with.

Hope that is helpful
Larry

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Re: Can you trust muni credit ratings

Post by Artsdoctor » Fri Sep 20, 2013 4:15 pm

I think that we can agree that all investments have some type of risk.

We've always known that issuers pay agencies for their evaluations. Additionally, we witnessed some very significant problems with muni insurers throughout the 2008-2009 meltdown. And now we've become aware of credibility challenges after the financial debacle 5 years ago. The S&P testimony was appalling and it's easy to understand the skepticism associated with ratings agencies' work now.

There is a lot at stake now with both Detroit and the California communities that have missed their pension fund contributions. Anyone interested in the muni market will be watching the bankruptcy cases very closely.

Nonetheless, you have to do the best you can with making as informed decision as you can when buying any investment. Munis are no different. If you feel that the ratings agencies have lost all of their credibility, you can simply avoid investing in munis altogether. Otherwise, you can try to diversify away some of the risk; one would think that the team at Vanguard would be savvy when it comes to adequately evaluating the muni market. And you can to keep the maturity less than 10 years (how can anyone anticipate the financial shape of a municipality 30 years from now?).

Personally, I think the ratings are a piece of the puzzle and would not make a decision to buy an individual muni based on ratings alone. If you set your priorities to researching munis rated only AAA or AA, that would only be the first step. You'd then start to look deeper at evaluating the bond. This has always been the case, and I suspect that the majority of investors really never took the time to even read the Official Statement anyway. And now, the underfunded pension data are easier to obtain (at least on a state level) than ever before; this information will only help.

Most people, should they decide to invest in munis to begin with, would be served best by letting a well-run organization do the reserach for them; this translates into a mutual fund. If you're going to buy individual munis, you'll need to spend time researching each issue. Ratings are just the beginning. But I don't think this is anything new.

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Re: Can you trust muni credit ratings

Post by technovelist » Fri Sep 20, 2013 5:03 pm

Municipal ratings don't change rapidly? This happened in the long-ago time of... July 18th, 2013:

'The financial day of reckoning for Chicago that Mayor Rahm Emanuel has been warning of finally came Thursday when a Wall Street rating agency ordered a “triple downgrade” of Chicago’s all-important bond rating.

Moody’s Investors dropped the city’s bond rating from Aa3 to A3, citing Chicago’s “very large and growing” pension liabilities, high-fixed costs, “unrelenting public safety demands” and “significant” debt load.

“You don’t usually see a triple-downgrade unless there is a catastrophic event, such as a natural disaster or terrorist attack,” said Civic Federation President Laurence Msall.

“This is a financial hurricane event for Chicago. ... The city’s borrowing costs will rise dramatically and their ability to use creative financing is going to be limited because of the costs associated with having such a low rating.”'

http://www.suntimes.com/news/cityhall/2 ... ating.html
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Re: Can you trust muni credit ratings

Post by larryswedroe » Fri Sep 20, 2013 5:14 pm

artsdoctor
Well you can cite one single change that was "big" yet it was not from investment grade to default (like Lehman or Penn Central RR many years before) and not even from investment grade to non investment grade, but just levels within investment grade. Now take look at cities like Detroit or others that are in trouble--their troubles have been well known for years and investors had plenty of time to get out before crises arose.

I suggest you look at the transition data I published above that demonstrates that munis have very strong persistence in ratings, with only small amount of changes occurring and typically small in levels of change.

BTW-I will add this, we will not buy a bond that fits our credit criteria if the market is pricing it as lower rated credit. While some will treat it as bargain, we assume market is more right than credit agencies which do tend to lag in making changes.

Best wishes
Larry

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Re: Can you trust muni credit ratings

Post by afan » Fri Sep 20, 2013 5:42 pm

I would not rule out muni's entirely, but I would find the ratings nearly meaningless. I agree one needs someone to do careful analysis of the bonds. Vanguard will do this for a very low price. I don't see the payoff in trying to do it myself. It would take a lot of time, and all I get is, maybe, a slightly higher return. If I were going to do it, I would look at state GO's. They should exist in large enough amounts for me to have some confidence in market pricing. Discovering those prices would be another reason not to do it myself.

As for the bonds falling slowly, besides the question of whether that is true, it is not very reassuring. When the bonds drop, so does your investment. You can get out, but you will have already taken a loss.

But I do Vanguard for muni funds. At 0.12%, it is hard to see a reason to go another route.
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Re: Can you trust muni credit ratings

Post by jdb » Fri Sep 20, 2013 7:06 pm

technovelist wrote:Municipal ratings don't change rapidly? This happened in the long-ago time of... July 18th, 2013:

'The financial day of reckoning for Chicago that Mayor Rahm Emanuel has been warning of finally came Thursday when a Wall Street rating agency ordered a “triple downgrade” of Chicago’s all-important bond rating.

Moody’s Investors dropped the city’s bond rating from Aa3 to A3, citing Chicago’s “very large and growing” pension liabilities, high-fixed costs, “unrelenting public safety demands” and “significant” debt load.

“You don’t usually see a triple-downgrade unless there is a catastrophic event, such as a natural disaster or terrorist attack,” said Civic Federation President Laurence Msall.

“This is a financial hurricane event for Chicago. ... The city’s borrowing costs will rise dramatically and their ability to use creative financing is going to be limited because of the costs associated with having such a low rating.”'

http://www.suntimes.com/news/cityhall/2 ... ating.html
Probably very off topic but within week of that downgrade I purchased City of Chicago GO muni bonds at what I considered good yields. They do have financial issues but I am willing to take risk that the City of Chicago will never default. Same for the Great State of Illinois as to which I am owner of GO bonds after downgrades with nice yields. All life is a risk and not afraid of these investment grade GO muni bonds despite rating downgrades.

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Re: Can you trust muni credit ratings

Post by Artsdoctor » Fri Sep 20, 2013 7:56 pm

Larry: I believe Techno pointed out the Chicago example, not me.

Afan: Your argument for sticking with state GO bonds is exactly what Vanguard's research supports. They believe that a fund has the manpower to tease out which bonds are worth taking risk on (for example, you'll notice the national muni fund even holds a reasonable number of revenue bonds which might be rated A or BBB, or even Puerto Rican bonds) in order to shorten maturity but increase yield; their AVERAGE credit ratings are high though. A prudent individual investor buying individual bonds would naturally gravitate to the safety of AAA or AA GO bonds because of risk aversion but inherently loses yield in the process of striving for safety. (Those of us in California have a dilemma, I must admit . . . )

I think there's a reasonable argument to be made for a combination of funds and individual bonds. For me, I only buy what I believe to be to highest quality individual munis and use funds for the majority of my municipal investments. I will admit that I spend a lot of time deciding to buy an individual muni and I do it with the assumption that I will hold it until maturity. And I heavily use EMMA to make sure I'm not being taken advantage of any more than what I perceive to be a reasonable degree!

I do agree with Larry 100% with the concept of finding a yield that seems too good to be true. I always look at posted average yields (for example, a 10-year NY muni generally yields "X" amount). If there's something that seems uncharacteristically high, I avoid it. The market, I presume, knows something that I don't.

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Re: Can you trust muni credit ratings

Post by larryswedroe » Fri Sep 20, 2013 8:14 pm

arts sorry about that
AFAN
If muni ratings are meaningless how do you explain the extremely high persistence of the ratings--meaning ratings are predictive.

JDB
FWIW I would not touch Illinois bonds with a 10 foot pole. There is no question the state will default. IMO it's only a question of whether they default on the bonds, or default on the pension obligations. Is it worth taking that risk for a bit more interest? If want risk far better to take it on equity side IMO
Remember it takes an awful lot of interest to make up for unpaid principal
Larry

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Re: Can you trust muni credit ratings

Post by jdb » Fri Sep 20, 2013 8:25 pm

larryswedroe wrote:arts sorry about that
AFAN
If muni ratings are meaningless how do you explain the extremely high persistence of the ratings--meaning ratings are predictive.

JDB
FWIW I would not touch Illinois bonds with a 10 foot pole. There is no question the state will default. IMO it's only a question of whether they default on the bonds, or default on the pension obligations. Is it worth taking that risk for a bit more interest? If want risk far better to take it on equity side IMO
Remember it takes an awful lot of interest to make up for unpaid principal
Larry
But Larry, with all due respect you said in this thread that historically there was almost zero default rate on investment grade GO's. The Illinois GO bonds are investment grade. I suspect has been long time since any state defaulted on its GO bonds.

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Re: Can you trust muni credit ratings

Post by rkhusky » Fri Sep 20, 2013 8:32 pm

Jack wrote: I realize that this is a difficult concept to grasp because it is so backwards and counter-intuitive but it really is the way it works. It is so crazy that it defies common sense, but that is the way it works and the way bankers have set it up.
It is no so difficult to understand. The same thing happened with home appraisers before the mortgage crisis. But I still believe that market forces will tend to keep things roughly honest over the long term. After the mortgage crisis, banks required appraisers to be much stricter, perhaps over correcting. I believe large purchasers of bonds will work to keep rating agencies in line. Some have suggested that Vanguard does there own analysis of bonds, but the text that I copied from their website seems to indicate that they use the credit rating agencies' valuations.

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Re: Can you trust muni credit ratings

Post by larryswedroe » Sat Sep 21, 2013 7:38 am

jdb
You care to bet that if Illinios defaults it will be years after they lose an investment grade rating?
And FWIW, I would not invest below AA and also avoid some large sectors of the market, and we won't even buy ANY bonds from the 6 states now with the worst adjusted net liabilities and won't even buy the GOs of the states in the next tier above 100% ANL.
Larry

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Re: Can you trust muni credit ratings

Post by YDNAL » Sat Sep 21, 2013 8:20 am

larryswedroe wrote:Obviously an important issue given the failure of the agencies in the MBS market. My view is that this is a very different story

http://www.cbsnews.com/8301-505123_162- ... uni-bonds/

Larry
I have difficulty, knowing the precedent, relying on a rating source that is hired by the entity being rated. A "different story"... ?
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Re: Can you trust muni credit ratings

Post by learning_head » Sat Sep 21, 2013 8:44 am

Larry, from your article:
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.
Why would not take away be: don't even bother with ratings - look at how the market prices the bonds, and that would be a better indication of how risky the bond is...

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Re: Can you trust muni credit ratings

Post by rkhusky » Sat Sep 21, 2013 10:02 am

YDNAL wrote:
larryswedroe wrote:Obviously an important issue given the failure of the agencies in the MBS market. My view is that this is a very different story

http://www.cbsnews.com/8301-505123_162- ... uni-bonds/

Larry
I have difficulty, knowing the precedent, relying on a rating source that is hired by the entity being rated. A "different story"... ?
When we applied for a HEL, we paid for the appraisal and we wanted as high a appraisal as possible to maximize what we could borrow. However, we had to use an appraiser that the bank approved of. So, if there was any outside influence in the home valuation, who had more influence, the bank or us?

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Re: Can you trust muni credit ratings

Post by rkhusky » Sat Sep 21, 2013 10:04 am

learning_head wrote:Larry, from your article:
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.
Why would not take away be: don't even bother with ratings - look at how the market prices the bonds, and that would be a better indication of how risky the bond is...
That's fine for those that have the time and expertise to dig into the details. But, for the rest of us who buy bond funds, we have to rely on the distribution of ratings provided by the fund company (or Morningstar).

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Re: Can you trust muni credit ratings

Post by YDNAL » Sat Sep 21, 2013 1:32 pm

rkhusky wrote:
YDNAL wrote:
larryswedroe wrote:Obviously an important issue given the failure of the agencies in the MBS market. My view is that this is a very different story

http://www.cbsnews.com/8301-505123_162- ... uni-bonds/

Larry
I have difficulty, knowing the precedent, relying on a rating source that is hired by the entity being rated. A "different story"... ?
When we applied for a HEL, we paid for the appraisal and we wanted as high a appraisal as possible to maximize what we could borrow. However, we had to use an appraiser that the bank approved of. So, if there was any outside influence in the home valuation, who had more influence, the bank or us?
As borrowers,
1. You want to rate your real property. The bank refused.
2. Municipality A wants to rate their intangible property. We all should refuse.
Landy | Be yourself, everyone else is already taken -- Oscar Wilde

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Re: Can you trust muni credit ratings

Post by larryswedroe » Sat Sep 21, 2013 2:39 pm

Jdb
I did say that and it is true. Doesn't mean it cannot happen. There is always risk, that is one reason muni yields are relatively high to Treasuries. And doesn't mean default will result in losses either. And also investors don't have to wait to default, they can sell well before (likely) as a rating migrates down if it does.
larry

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Re: Can you trust muni credit ratings

Post by larryswedroe » Sat Sep 21, 2013 2:41 pm

learning hand,
Yes you could do that but investors don't have access to yields generally--they are buying funds
We however do rely on the market as I noted.
Larry

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Re: Can you trust muni credit ratings

Post by jdb » Sat Sep 21, 2013 3:29 pm

larryswedroe wrote:jdb
You care to bet that if Illinios defaults it will be years after they lose an investment grade rating?
And FWIW, I would not invest below AA and also avoid some large sectors of the market, and we won't even buy ANY bonds from the 6 states now with the worst adjusted net liabilities and won't even buy the GOs of the states in the next tier above 100% ANL.
Larry
Thanks Larry. Appreciate your comments. You are admirably concerned with credit since you are buying bonds for customers and have to report to them. I am buying for my own account and have no one to report to (other than my wife but that is another topic) so could take more risk. And I hark back to your comment that there is almost no default historically in investment grade GO's. Seems to me that might be worth going down credit ladder to get better yields provided kept to investment grade GO's and kept to short term maturities, say not more than 5 years from date of purchase.

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Re: Can you trust muni credit ratings

Post by afan » Sat Sep 21, 2013 4:30 pm

Larry,

You have started yet another fascinating discussion.

Investing in the bonds of municipalities in trouble is like investing in Greek debt. The issuer will not, can not, pay in full the obligations it has assumed. There may have been a time when, due to fraud, or failure to pay attention, this was not fully recognized. But now everyone knows it. This does not mean their bonds are worthless. It means that buying them is speculating that the market will price them slightly higher at some point in the future, that you will get enough interest to make up for any drop in face value, or both. In part, it is betting that political solutions will appear to protect bond holders. All that might happen in Greece, and it might happen for IL. But I don't see the payoff to speculating in bonds, so I am not interested in doing it. I find the issues fascinating, so entertaining to read about, but not to seriously consider investing.

Defaults in muni bonds have been very rare. This is why he bond insurers, for a long time, had the ability to print money. They insured against something that was very unlikely to happen, and had a near zero risk for the top credit quality issues.

Persistence. Let's distinguish between persistence of the financial status of an issuer and persistence of a rating. As you yourself note, the ratings tend to trail changes in the financial status of the issuers. So, to an extent, persistence in ratings reflects the reluctance, or negligence, of ratings agencies to recognize these changes. If you are primarily concerned with having stable ratings of the bonds you own, the persistent ratings are reassuring. However, individual investors are more likely to care about persistence of the financial status of the issuers. That is not as stable as the ratings.

Investors care not only about default, but also about loses in the value of their bond holdings. That happens if the market perception of credit quality declines. This is a real loss whether one holds or sells the bonds. The rarity of defaults means that buying "decent" credit quality munis brings with it a low risk of default. However, that does not mean your bond portfolio cannot lose money due to credit risk. As others have pointed out, the best indicators of the credit quality of issuers is the market price of their debt. This is far better and more timely than the ratings.

For an individual investor it is not that easy to find the market prices, and the reliability of the market prediction depends on how closely the market follows an issue. So I would trust the current market "rating" of IL GO bonds. A huge number of munis are small issues, tied to poorly publicized municipalities or revenue streams, and thinly traded. For these, even the market price may be a pretty stale guess as to credit quality. The appeal of state GO is not so much that "no state will ever default", but that states are large enough entities that one can trust the market to follow credit quality.

Speculation about state defaults quickly takes one into political considerations that do not belong on Bogleheads, but just as with other potential defaults by major issuers, political implications will be involved.

But if one is to take stock-like risk, one should expect stock-like rewards. For people who trade bonds for a living, and use lots of leverage, this may pay off. For an individual it is hard to see the risk as worth the reward. It is almost free to get a well diversified portfolio of bonds that have been screened by Vanguard. I suspect that putting a lot more effort in trying to beat the bond market would not raise the return by nearly enough for me to find it worth it.

Of course, there will be investors for whom this sort of "investment grade speculation" is part hobby, and as long as their returns are similar to Vanguard, they are happy.
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