Chicago Bonds Watch: Credit Ratings vs. Market
by meep
Here’s what a recent Chicago bond trade did:
A $2 million block of Chicago general obligation bonds maturing in 2023 sold at nearly 315 basis points over top-rated munis* on Thursday, according to Municipal Market Data, as the market continues to digest the city’s downgrade to junk two days ago.
The bonds, which carry a 5 percent coupon and yielded 3.75 percent when they were originally issued in March 2014, sold off cheaply at 5.119 percent and 99.25 cents on the dollar on Thursday.
They last traded two months ago at 107.044 cents on the dollar and 3.94 percent – a sharp 118 basis point uptick in one trade.
The problem with trying to capture bond prices is that they are traded relatively infrequently compared to public stocks (as an example). A 118 basis point (i.e. 1.18% percentage point) jump in yield is a huge change, but in a thinly traded market (like bonds) it’s not necessarily unusual.
I really can’t get into bond data right now, because that does cut into my day job, but you can check this out. That’s spread for BBB-rated corporate bonds (BBB is the lowest rating that qualifies as investment grade).
Let’s just say a 315 bp spread is not reflecting investment grade.
But what are the rating agencies doing? We’ve seen that Moody’s downgraded Chicago GO bonds to junk status, but not all other rating agencies are following in its footsteps.
While Moody’s has dropped the city’s debt rating by seven notches, to Ba1, one level below investment grade, since mid-2013, Standard & Poor’s Rating Services has maintained an A-plus rating—five rings from the top—for more than four years.
The six-notch spread is the widest for any city, creating challenges for debt traders.
“The market is having difficulties on price discovery,” John Donaldson, who helps manage about $700 million of munis, including Chicago debt, tells Bloomberg. The director of fixed income at Haverford Trust in Radnor, Pa., adds, “What level should something with that big a gap trade at?”
As someone later says in the article, the ratings agencies lost a lot of credibility in the financial crisis, and rightfully so.
Maybe Moody’s is overreacting. Maybe S&P and Fitch are underreacting.
I am going to reach back to some stuff I wrote in 2009, when the Dodd-Frank bill was being worked out.
Heck, can the rating agencies do a good job rating government bonds?
There were many things that made me wonder about this, but one of the main ones is that governments need the ratings agencies to rate their bond issues, and that governments have powers that most other annoyed bond issuers do not. Also, governments have large pension funds that are huge investors in bonds, and need the ratings for investment decisions.
Examples:
- S&P was sued by the federal government in 2013, but other ratings agencies weren’t. The assumption was it was payback for S&P downgrading U.S. debt in 2011. Seems like a pretty solid theory.
Pension fund investors lost billions of dollars trusting the rosy credit ratings stamped on troubled mortgage securities before the 2008 crisis. In its aftermath, they have spent years and many dollars suing Moody’s and Standard & Poor’s, the main purveyors of those dubious grades.
That these funds and other plaintiffs are trying to hold the ratings agencies to account is a good thing.
And yet, there’s a mystifying disconnect in some of these disputes. On one hand, pension funds or state officials are telling the courts that Moody’s and S.&P. were negligent and their ratings marred by flawed methods and conflicts of interest. On the other hand, when the professionals who manage state funds buy bonds or mortgage securities, their investment policies require them to rely on the assessments of — you guessed it — the very same ratings agencies.
It’s not only pension funds that require bond ratings for their bond investments. Lots of institutional investors (insurers, endowments, trusts) have such requirements.
- While the lawsuit against S&P (while leaving Moody’s alone) was bad enough, it’s not as bad as what Italy did to all three major rating agencies: investigated them for criminal activity. The last item I can find is from 2014. I haven’t kept up with that particular case.
- I noted a new entrant into the ratings game back in 2011. As noted, the new entrant, Kroll, is paid by issuers (as opposed to subscribers). So it’s not like this conflict of interest issue is going to be resolved.
Anyway, let’s get back to Chicago.
While S&P did downgrade Chicago, it’s still in the investment grade range. Mark Glennon at Wirepoints makes the following remark:
Comment: Why the discrepancy with Moody’s downgrade to junk? Has nothing to do with S&P hired by the city to do the ratings on that upcoming $806 million offering by the city, right? Couldn’t be.
I guess we’ll see if they go ahead with this bond issue.
Chicago plans to sell $806 million of bonds in the next four weeks, refinancing floating-rate debt that exposed the city to penalties after its credit rating was cut to junk.
The deals are part of a move to convert about $900 million of variable-rate debt to fixed-rate. Chicago plans to price offerings of $201 million and $182 million on May 19, according to data compiled by Bloomberg. A additional four sales totaling $423 million will follow through early June, according to Kroll Bond Rating Agency.
I guess they have to go through with it, because the variable-rate debt is killing them. The creditors on that deal are calling in the downgrade trigger (or on swaps, it’s not clear to me which deals Chicago has outstanding that involve downgrade triggers.) Obviously, Chicago doesn’t have the cash on hand to meet the cash demands the downgrade triggers require, so they’d have to issue bonds.
I’m curious:
- What the yield will come in at.
- Who will be buying these
Alas, there are a lot of mom-and-pop investors in the muni market because of their (til now) perceived safety, as well as the tax benefits. There are also institutional investors who are desperate for yield, and if there’s a patina of investment gradedness about it due to Kroll and S&P, they could be going for it.
But they may want to hang fire. More about that tomorrow.
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