What's in a rating?
As the municipal bond market has taken hits from large bonds trading at default prices or facing the risk of default in the past year, bond quality ratings continue to be an area of focus across the credit markets with extra focus on the volatility in the corporate high yield markets. Questions are being asked about how to gauge which municipal bonds to invest in, and how big of a factor the credit quality of a fund really is. Below Michael Walls, the Portfolio Manager for the Waddell & Reed Advisors Municipal High Income Fund, discusses how a rating is determined, how he views ratings and his outlook for the municipal bond market.
When reviewing the holdings of funds with a municipal bond component, one thing most people will look for early on is the credit ratings of the underlying investments in the fund.
And this would seem to make sense. You can gauge the potential risk of any fund based on the level of bonds rated at various levels. Any investments listed as “junk bonds” could bring higher returns – but also carry a higher level of risk. A municipal bond issuance that isn’t rated at all should then be considered the riskiest of investments, right? Not so fast.
A bond can be considered unrated for various reasons, not all of which are related to the risk or return associated with the issuance.
Depending on what ratings companies the fund works with, they may simply not know the rating for certain bonds. There are three main companies that supply ratings for municipal bond offerings: Standard & Poor’s, Moody’s and Fitch’s. Each company charges for a bond to be reviewed and a rating issued. Many issuers may only pay for one or two companies to rate their bonds. When that happens, if you subscribe to the third company, that bond will show as “unrated.”
Here is an example. City A wants to issue some general obligation bonds. They contract with Moody’s to review and rate their offering. Moody’s gives them an AA rating. If an investor looks at the information for this issuance on the website for any rating company except Moody’s, this will not show as an AA rating, however – it will show as unrated. The same holds true when that bond is part of a larger fund.
Because it costs to be reviewed and rated, some municipal bonds choose not to be rated at all. Examples of this would be issues from schools, hospitals and smaller governments. For many smaller issuances, it can be deemed not fiscally responsible to pay for a rating.
In addition, some purchases would be for land deals. Because the actual investment is undeveloped land, there would be no rating available. So why buy these bonds? Because the belief is that, someday, that land will be slated for development. When that happens, the bonds will be “pre-refunded”, which will potentially result in an enhanced credit quality and improved valuation, due to escrowed Triple-A U.S. Treasury securities that secure the pre-refunded bonds.
As portfolio manager for the Waddell & Reed Advisors Municipal High Income Fund, I believe strongly in investing in issuances that make sense in the long run. With the current market offering few new opportunities of any size or substance, it is even more important now to stick with offerings we know and include a cash component in case of a market downturn for municipal bonds. I see the current market as an issuers market, with no truly attractive large deals available right now. Although we have always included non-rated issuances in the Fund, this fact is a large part of why we have looked to the non-rated market for recent purchases. While many funds have bought high-quality municipal bonds that they lever up using a line of credit or inverse floaters, we don’t feel the market is attractive enough to do that right now. The demand for what is available is so strong that these offerings are being broken up into small allotments and the rates decreased because of the demand. While it can be considered standard practice to leverage investments in order to show a credit rating, the Fund does not do that. We feel there is more transparency for the investor if we simply show what we have invested in, rated or not.
So where have we put our focus? Not in all the typical places. We’re underweight against our benchmark in hospitals and healthcare because we are still trying to determine the full cost of the Affordable Care Act and how that could affect bonds in this arena. We have less than 4% exposure to Puerto Rico. We have put the majority of the bonds we own in revenue-specific projects that are not tied to a specific state.
Is this the correct approach? None of us have a crystal ball, but I believe it’s the right path given the opportunities we see in the current environment.