5.6 Credit Ratings
Publicly offered municipal debt securities are generally assigned a credit rating by one or more credit rating agencies. Credit ratings reflect the opinion of the credit rating agency as to the probability that interest or principal payments on a security will not be paid in full and on time. Credit ratings provide an independent assessment of an issuer’s credit risk derived from a systemic, uniform guide to creditworthiness. Investors may use ratings to supplement their evaluation of how much return they expect in terms of a bond’s value, relative to an estimated probability that the issuer or obligor may default on paying its obligations. A bond with a strong credit rating would be assessed to have a lower likelihood of a payment default than a bond with a lower rating. The sections below provide more detail on rating systems.
Because different obligations payable by a particular obligor with a particular priority from a particular source present the same credit risk, reference is often made to an issuer’s “rating.” In California, this term usually refers to the agency’s general obligation bond rating, whether or not they have actually issued such bonds. A public agency may, however, have bonds with differing ratings. Obligations payable from a city’s general fund, for example, may be rated A+, while obligations payable from the revenues of the city’s water utility and secured by a senior lien on those revenues are rated AA and obligations payable from the revenues of the city’s water utility and secured by a subordinate lien on the revenues are rated A.
While bonds and other debt obligations are generally not legally required to be rated, in most cases issuers find it to their advantage to obtain credit ratings. Ratings are, in most cases, directly associated with interest costs. Issuers should expect to pay investors higher interest rates on lower rated debt, and it is often difficult and cost prohibitive to sell unrated debt.95
The use of credit ratings may also help an issuer to achieve a broader reception for its debt in the municipal market than for unrated debt. Some institutional investors, for example, including mutual funds, investment trusts and managers of public funds, are restricted by law or by the terms of their controlling legal documents and governance policies to buying securities at or above specified credit rating levels, so the use of credit ratings may help ensure that an issuer’s debt is eligible for institutional investor consideration. Many other investors may apply credit criteria and strategies informally. The general acceptance and uniformity of credit ratings as stable and reliable assessments of credit risk levels may help conduit issuers to establish a minimum level of credit risk exposure (risk tolerance) for prospective investors by applying credit rating requirements for conduit borrowers/ debt issuances. For example, as a matter of policy, California’s Educational Facilities Authority and Health Facilities Financing Authority require a minimum “A” rating either through credit enhancement or on a “stand alone” basis, although on a case by case basis they will permit a “BBB” or “Baa” rating if additional collateral (such as a deed of trust) is posted.
Ratings are also important to the secondary market, where investors can sell their bonds.96 The additional liquidity provided to investors in rated securities translates into lower initial interest rates for the issuer.