Why the bond rating system works

In its March 11 editorial, “Rethinking state bond ratings,” The Times editorial board suggested that because state and local governments default on their obligations less often than corporations do, all bonds issued by governmental entities should automatically receive high ratings from credit rating agencies such as Standard & Poor’s (S&P). Several officials made the same suggestion at a hearing before the House Financial Services Committee earlier this month. Such a “wholesale” upgrade would prevent ratings from doing the very thing they are designed to do -- reflect the individual credit risk associated with each bond.

Credit ratings are assessments of the likelihood of default given all available factors. So, although the likelihood that a bond issued by either Beverly Hills (rated AAA) or Stockton (rated A+) will default is very low, that does not mean that both municipalities deserve the same rating. This is because the credit profiles and economic fundamentals of those two communities differ. An effective rating system needs to reflect these differences in order to help investors make better-informed decisions.

S&P has been systematically reviewing and upgrading a large number of U.S. public debt instruments over the last several years in response to their generally lower default rates. The result has been higher ratings for those bonds that truly deserve it. In 1986, only about 20% of municipal bonds rated by S&P held AAA or AA ratings; by 2007, more than 35% were rated that highly. It is also important to note that more than 99% of rated municipal issuers are investment grade, compared with less than 20% of corporate issuers that S&P has rated in recent years.

That said, municipal bonds do default. Our recent municipal transition and default study shows 34 defaults by issuers rated by S&P between 1986 and 2006. And just recently, two municipal entities -- Jefferson County, Ala., and Vallejo, Calif. -- have been downgraded substantially due to increased financial uncertainty that they can meet their debt obligations. Officials in Jefferson County recently stated that they could “provide no assurance that net revenues ... will be sufficient to permit the county to continue to meet its debt obligations,” and revenue shortfalls in Vallejo have led that city to consider filing for bankruptcy.

One of the reasons rated municipal bonds have lower default rates than corporate bonds is because the municipal bond market tends to be self-selecting. Higher-risk municipalities that are more likely to default often choose not to have their bonds rated at all. During 2007, for example, S&P rated only about 40% of the municipal bonds coming to market. Information obtained by S&P Securities Evaluations confirms that there were more than 1,100 municipal issue defaults between 1986 and 2007, but only 167 of those -- about 15% -- were rated by any rating agency.

It is also important to point out that governments and corporations are very different entities with different goals, rules and responsibilities. Although both can raise additional funds by issuing bonds, the options open to each if they find they cannot meet their debt obligations are very different. Generally speaking, corporations can move quickly to restructure, refinance, declare bankruptcy, transfer operations overseas to reduce costs or go out of business altogether. Few of these options are realistically available to governments, which must stay in business where they are and continue to provide services to their constituents -- even if it means defaulting on their debt.

Lastly, not all municipal bonds are created equal, nor are they all governmental. Nonprofit organizations such as hospitals, institutions of higher education and housing and highway authorities also issue bonds that are part of the muni market. Those debt instruments have been less stable than government-issue bonds and need to be identified as such.

S&P’s ratings opinions and analyses are designed to bring transparency to the global credit markets to help facilitate access to capital. Our ratings also help investors determine which bonds and issuers might meet their individual risk tolerance and investment objectives.

The global credit markets benefit from standards and benchmarks that are understood by all, which is why we use the same scale across all sectors. We will continue to revise and refresh our criteria as appropriate, and we anticipate further upgrades in the U.S. public finance sector assuming that creditworthiness, particularly in governmental credits, remains strong. We also will continue to work with regulators, legislators and market participants to promote a greater understanding of credit ratings and to support the efficient operation of these markets.

Steve Zimmermann is managing director of corporate and government ratings for Standard & Poor’s.