Credit ratings are an important tool to evaluate a municipal bond’s repayment capacity in different economic scenarios. So it makes sense for investors to learn about the parameters used to assign a particular rating for their potential investments. Though the concept resonates with every investor, very few understand the intricacies surrounding the composition of a credit rating. The same goes for the issuers of municipal debt. An issuer may be completely familiar with its finances, operations and organization, but when it comes to understanding its credit profile and the matrices used by the credit rating agencies to determine a credit rating, they may be completely oblivious.

In this article, we’ll take a closer look at the criteria agencies use to assign ratings for different types of debt instruments. We will also examine certain circumstances under which these rating parameters can change, thereby, affecting the ratings.

Keep our glossary of municipal bond terminologies handy to familiarize with different concepts commonly used by municipal investors.

In general, there are two forms of municipal debt issued by local government: general obligation debt and revenue backed debt. For general obligation debt, a local government enters a “full faith and credit pledge” to levy unlimited – although, in some cases limited – ad-valorem property tax to meet its debt service obligations. The ad-valorem tax is based on the value of the property. For local governments, property tax revenues are often the main source of general funds revenues, which are used to maintain services like police, fire, public works, etc. Under the “full faith and credit,” some government entities can raise these taxes to any amount necessary to meet their obligations, better known as the unlimited ad-valorem tax.

In revenue backed debt, as the name suggests, the municipal debt is secured by the revenues generated by municipal utilities providing various services essential to functional economies. Some of the major services/utilities are water distribution, electricity distribution, gas distribution, wastewater disposal, stormwater removal, and solid waste disposal. These essential services are provided to its users at a rate, which creates a stream of revenue for that enterprise. This stream of net revenues, after the payment of regular operations and maintenance expenses, is often pledged to secure any debt issuances.

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In the credit rating analysis of general obligation debt, there are two main areas typically considered.

1. What level of taxation can the municipality’s tax base bear?

2. What essential services (police, fire, etc.) and retiree benefits should the local government maintain with their taxing power?

Check out our guide on the differences between general obligation and a revenue muni bond here.

Here are the few areas that are closely examined before rating a general obligation debt:

• Sustainable Tax Base: The main basis for repaying general obligation debt is the strength and ability of the local economy – which includes the size, diversity of employers, and strong tax base – to meet its financial obligations. Since the properties, their diverse ownerships, and their values are critical for sustainable tax-base income levels, they also play an important part.

• Financial Preparedness: A local government’s organization style and financial preparedness determines its ability to withstand any potential downturns and sustainability. This preparedness isn’t limited to its reliance on general fund revenues, but it also takes into accounts the potential policies in place for an unforeseen event including reserve fund policy, liquid resources and feasibility of long-range financial plans.

• Management Track Record: The organizational framework of a local government creates the ability to meet its financial obligations. One of the crucial things is its ability to maintain a balanced budget. This area also takes into account the local government’s ability to establish sound financial policies and stick with them.

• Debt and Pension Obligations: Almost every local government has a debt portfolio and retiree pension obligations that are crucial to be met. This indirectly measures the financial leverage of a local government. What is alarming, as most of us might know by now, is that several local governments in the U.S. are struggling to plan for their unfunded liabilities on their pension funds for retirees.

In the credit rating analysis of revenue backed debt, it’s critical to understand the nature of the utility: its size, coverage/service area, strength of rate management and the financial strength of its overall operations. Another important point to note here is that credit profiles and ratings of essential service utility revenue bonds like water management systems are generally stronger than that of non-essential service revenue bonds like telephone and cable television.

Here are the few areas that are closely examined before rating a revenue backed debt:

• System Characteristics: This parameter measures the utility’s ability to fund its operations and capital needs in the future, based on the size and complexity of its operations, financial strength of its service base, and health of its capital assets.

• Financial Strength: This area is crucial in understanding a utility’s preparedness to handle any potential financial strains on its revenues. For example, due to the droughts in California, the state’s government introduced many measures for people to conserve water, which substantially decreased the water usage in California and in turn had a huge negative impact on local utility revenues.

• Management Track Record: This area refers to how the management team manages the utility rates charged to consumers, prepares and allocates the budget, and develops contingency planning to face adversaries in the future. These factors are crucial to determine the financial strength of any utility. Going back to the California example, the low water usage was compensated by raising the water rates by some local governments.

• Legal Provisions: This area refers to the debt structures and utility’s obligation to meet various debt covenants with its revenues; essentially, these debt covenants are the minimum standards that the utility must legally meet, but are often exceeded by the utility’s revenues.

Be sure to check this article to remain aware of the due diligence process for evaluating municipal bonds.

Before making investment decisions, a simple glance at the credit rating of any given municipal debt instrument isn’t enough.

It’s imperative for investors for understand the basis of any credit rating, since each municipal debt can have its own criteria in determining the financial strength of its revenues. Investors should also consider the treatment of their investments in the event of Chapter 9 filings of any local governments. Its also important to understand that local governments and their revenue sources are quite different from the federal government and often run independently from one another. Hence, the financial policies of the federal government may or may not have a direct impact on the local government’s revenues.

Know how to avoid municipal bond headaches caused by bankruptcy concerns using bond insurance.

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