Rating Municipal Bonds: Safe Investments - dummies

Rating Municipal Bonds: Safe Investments

Municipal bonds are very safe animals — at least those rated by the major rating agencies (such as Moody’s), which are the vast majority of munis. If the mild nature of the beast weren’t enough to put your investing soul at ease, know that roughly two-thirds of municipal bonds issued today come insured; you can’t lose your principal unless the issuer and its insurance company go under.

Such a disaster is unlikely to happen. And even if the insurance company were to fail, the general feeling among industry insiders is that most states would be quite reluctant to allow one of their cities to default on a general obligation bond.

Like the corporations that issue corporate bonds, the entities (cities, hospitals, universities, and so on) that issue municipal bonds are of varying economic strength — although the degree of variance isn’t nearly as large as it is in the corporate world.

A study from Moody’s found a huge difference in recovery rates of munis as compared to other bonds. The recovery rate is the amount of money bondholders get back after the dust of a default settles. On defaulted munis from 1970 to 2000, the recovery rate was 66 percent of the face value of the bonds. In contrast, the poor corporate bondholders got back only 42 percent of the face value on their defaulted bonds.

Municipal bonds, like corporate bonds, are rated by the major bond-rating agencies. But they have their very own rating system. (If municipalities were rated using the corporate ratings, almost all would hug the very top of the scale.) This table shows the credit quality ratings used by three major bond-rating agencies: Moody’s, Standard & Poor’s, and Fitch.

Credit Risk Moody’s Standard & Poor’s Fitch
Prime Aaa AAA AAA
Excellent Aa AA AA
Upper medium A A A
Lower medium Baa BBB BBB
Speculative Ba BB BB
Very speculative B B B
Very, very speculative Caa CCC CCC
In default Ca, C CC, C, D CC, CCC, D