CDIAC panel drills down into ratings landscape

With the cost rising and methodologies changing, the California Debt and Investment Advisory Commission hosted an online webinar Tuesday to help issuers navigate the evolving world of bond ratings.

Robert Berry, CDIAC's executive director, shared the commission's analysis of the cost structure of obtaining ratings ? and changes, such as a trend toward issuers seeking fewer ratings to lower costs. His team's analysis shows the cost of obtaining ratings has outpaced inflation.

The panelists ? David Brodsly, managing director at KNN Public Finance; Renee Dougherty, director of municipal research at Charles Schwab Asset Management; Eric Hoffmann, associate managing director at Moody's Ratings; and Debra Wagner Saunders, consultant at BondLink and U.S. Department of Energy ? covered the topic from all angles.

"The cost of getting a rating is considerable," said Saunders, a former Citi banker, who moderated the panel. It is "not just what you pay the rating agency, issuers also spend quite a bit of time strategizing with their finance team about how to approach rating agencies."

Given that costs have increased and the methodology has changed, Saunders said, the panel sought to give issuers pointers on how to adapt and make their credit presentations as good as they can be.

One significant change is smaller issuers are seeking only one rating to save money, Berry said.

This fits the Government Finance Officers Association advice to contemplate the fee structure when deciding how many ratings to secure for each credit, Berry said. "The ratings involve a strong commitment of resources," he said.

Rating agencies have made significant changes to their methodologies over the past few years to better account for common challenges faced by municipal issuers with a focus tuned more toward broader sectors, like cities, as opposed to more specific credits, like water and power, Berry said.

The changes in methodologies resulted from regulations adopted following the Great Recession, and how bonds have been treated in the San Bernardino, Stockton, Detroit and Puerto Rico bankruptcies, Hoffmann said.

"Cast your mind back 15 years, and that will explain the rating agency expectations," Hoffmann said. "I am referring to the Great Recession, it was the most serious downturn since the Great Depression."

In the years after the 2008 economic crash, the rating agencies faced criticism largely on how it rated mortgages and securities, which resulted in the Dodd-Frank legislation bringing greater scrutiny to the industry and resulting in greater transparency from the rating agencies, changes to methodologies and consistency in the application of ratings, Hoffmann said.

"It was not just regulatory changes, but then there was a string of municipal defaults, the most significant were Stockton and San Bernardino; and then Detroit."

"Those were significant broad-based defaults; they didn't default on narrow, specific pledges," Hoffmann said. "And it included types of debt that had sufficiency to pay, but were thought of as walled off from general government.

As an example, a water agency that had three times coverage may have defaulted under bankruptcy protection, another panelist noted.

Those aftershocks (the bankruptcies) were not driven by the recession, but they contributed to changes in rating agency methodologies, Hoffmann said. "We started to rely more on OPEB (other-post employment benefits) and pensions, and more sector methodology, rather than general obligation bond methodology, special tax methodology, and now we have cities methodology," Hoffmann said.

Rating agencies are less willing to rely on information provided by the issuer, and as a result began to track third-party information from auditors and the federal government more, he said.

Dougherty, who provided the investor perspective, said they prefer more than one rating. Saunders added when she worked as a banker they would advise issuers to seek a second rating, that way if they lost one, they wouldn't take a pricing hit from becoming unrated.

Institutional investors, who have large staffs to conduct their own analysis are less dependent on ratings, but they still like to have ratings analysis to help make decisions. At the other end of the spectrum, retail investors are more likely to rely more on ratings analysis to make investment decisions, so they are less likely to purchase unrated debt.

The panelists confirmed that ratings do affect pricing, because of those factors.

"The rating is a big factor in pricing," Saunders said.

There is an expectation that deals involving billions of dollars outstanding would have more than one rating, Dougherty said.

"If the state of California only had one rating, investors would wonder if you were trying to game the system," Dougherty said, alluding to the issue of rating shopping, where issues select a rating based on which rating agency will assign the highest rating.

"I had heard a lot of bond funds have a two-rating criteria," Brodsly said. "That might be an old standard, but we have advised [getting] two ratings, because it opened the deal up to those funds."

"I think that would vary from investment shop to investment shop," Dougherty said. "That really depends on their analytical capabilities and what part of the market they specialize in."

"We are recommending fewer ratings when the evidence isn't showing that having more ratings is drawing greater investor interest," Brodsly said.

He added, CDIAC's analysis is bearing out that issuers are seeking fewer ratings, because it doesn't look like the market is requiring multiple ratings for some issuers.

"I am not sure the differences (in methodologies between rating agencies) is perceived in the market," Brodsly said.

"Institutional investors know that issuers often rating shop," Dougherty said. "So, it doesn't hold that a higher rating will necessarily get you better pricing. Investors know that game. It's not just the rating that matters. We put a lot of value in the content of rating reports, that's more valuable than the rating itself. That helps to inform our individual analysis."

She noted rating agencies have access to management that investors do not, so they have a better idea of the quality of the management that isn't revealed in the reports produced by issuers, she said.

Hoffmann noted ratings analysts put a lot of time into the credits they are analyzing annually.

"My team is responsible for 1,500 names," Hoffmann said. "We review every annual report, updated financials and the budget each year," he said.

"One reason Eric and his team work so hard to get a full understanding of the issuers is because investors will grill them when they meet them, and they have to be able to answer all of the questions," Saunders said. "I have probably been a thorn in Eric's side, because I am like, "how did you get to that."

CDIAC provides educational programming on debt issuance, along with being the state's clearinghouse for public debt issuance information. It also assists state and local agencies with monitoring, issuance and management of public debt.