Financial Industry Insights from Advisors Asset Management


AAM Viewpoints – Reasonable Municipal Downgrades?

For the past several months, the rating agencies have been imposing new standards in the ratings of municipal revenue bonds by imposing ceilings on these ratings linked to the issuer’s general obligation (GO) pledge. This has resulted in downgrades of some well-known, and not-so-well-known, issuers despite no change in the fundamental credit profile of the revenue bond, or the related general obligation bond, issuer. In fact, some of these downgrades occurred in the face of an improving credit profile.

For Moody’s, these new rating limits, or ceilings, have been imposed as a result of a court decision involving Puerto Rico. The 1st Circuit Court of Appeals, a court whose jurisdiction does not cover most of the locations of the downgrades, ruled that Puerto Rico (a municipality in bankruptcy and default on its debt) is not required to pay debt service on "special revenue" bonds of Puerto Rico Highway & Transportation Authority during bankruptcy. The rating agencies are now reasoning that if any of these highly-rated credits get into that kind of trouble (i.e. default or bankruptcy), the general obligation (backed by the full credit and taxing power of the issuing jurisdiction) bond issuer may be tempted to impair the revenue bonds (backed by a specific revenue stream) of the issuer.

The downgrades presuppose that these highly rated issuers would interfere with special revenues of their wholly owned utilities/special taxes in a bankruptcy/default scenario. Some recent negative rating action using this rational include:

moody's rating changes

Moody’s also has several other issuers on review for a downgrade.

S&P is also lowering many of its special revenue/tax ratings imposing upward limits, indicating that all of the issuer’s obligations will be drawn into bankruptcy or some type of restructuring if the underlying credit enters into bankruptcy or defaults on its debt. A small sample is below:

S&P Rating changes

On the face of it, it appears that the rationale for large scale downgrades with an artificially imposed limit on a bond rating is flawed. This is due to four main reasons:

  1. The municipal default rate for investment grade credits is extremely low – the 10-year investment grade cumulative default rate, per Moody’s (general government through 2018) and S&P (through 2018) is 0.05% and 0.19%, respectively (also note the exceedingly low default probabilities of the related GO credit in the tables above – the credits that the rating agencies are worried about). Note that all the downgrades to date are based on the corresponding investment grade ratings of the government issuer which all have extremely low probabilities of default. By lowering these special revenue ratings, in some cases by multiple notches, due to an event (default) with an extraordinarily low risk (to the point where it is likely never to occur) seems over the top and a mis-representation of risk.

  2. Many of the downgrades are pegged to ratings of the applicable state government general credit. The rating agencies are saying that if a state were to file for bankruptcy or default, it would take other revenue-related bonds down with it (e.g. New York State, Illinois, Kansas, Pennsylvania, However, not only has this hardly ever happened in history (I believe the last state default was Arkansas in 1933, and before that in the 1840s), but states are prohibited from declaring bankruptcy. Again, the actual downgrades of state-related issuers (not all of which are mentioned in this report), implies a real risk that has increased, but is certainly not the case.

  3. The rating agencies fail to account for the location of the municipality, where some states prohibit municipalities from filing bankruptcies and other need permission from the state.

  4. Finally, even when including, non-investment grade ratings, the municipal default rate is quite low. For Moody’s, the 10-year overall cumulative and speculative grade municipal default rates (general government) are 0.07% and 1.99%, respectively. For S&P, the rates are 0.3% and 8.99%, including utilities and health care.

While there have been some recent high-profile defaults such as Puerto Rico, Detroit, and Jefferson County, AL, these remain quite rare and do not seem to justify the blanket large-scale downgrades and imposition of rating ceilings of municipal revenue bond issuers that are tied to the general obligation credit of the issuer. The downgrades are based on events that are exceedingly rare. Puerto Rico is a special case that is not representative throughout the market. These recent downgrades imply higher probably of defaults/risk than warranted and consequently do not properly reflect true risk. They also fail to fully recognize structural enhancements to bonds that can provide additional bondholder comfort.

CRN: 2019-0801-7588R 

An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price the trust paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.

credit ratings table

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit


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