MuniLand

The Wall Street Journal ran an odd article yesterday about the unpredictability of sovereign credit ratings that are below the investment-grade cutoff (BB+ and lower). Check out the table from the IMF of S&P’s sovereign ratings.

The WSJ article seemed to air some highly paid bond-fund managers’ whining that ratings were not a useful signal for when they should buy and sell bonds of specific countries. The complaint was also that ratings don’t include certain data sets that are important, such as fund flows in banks, and that they don’t have the agility of credit default swaps.

The guys quoted in the WSJ might be right on the data sets that raters use and they are certainly right about CDS being more agile than ratings. But ratings are not intended to mirror market sentiment like CDS does. They are supposed to stand above market panics and routs and give a 30,000 foot view of an issuer’s credit condition.

Raters should incorporate every type of information available to them. Markets want hot, accurate information. Raters create reputations for themselves for good analysis, and reputations rise and fall on good predictive ability. Information is money, and markets want to make money.

It’s a well known phenomenon in fixed-income markets that once a bond falls into the junk or speculative category that its rating becomes murkier for predicting default. So maybe credit ratings are more useful for investment-grade bonds and CDS are more useful for junk-grade securities? If there are any academic studies on the subject that you know of, please add them in the comments.

An interesting thing about muniland is that all states are rated investment grade. California has the lowest rating for a state at A-.  See it on the last line in the great chart above from Stateline. S&P has adjusted California’s rating 7 times in the last ten years, which is pretty active for rating change on a major issuer. But the CDS on California is moving every day!

The CDS for California was quoted at 235bp this afternoon by Markit, a 16% increase in price over last Friday. The CDS market is saying that California is a junk issuer. Reuters reported on Wednesday how revenues are falling in California and the CDS market seems to be picking this up and adjusting their signal before the rating agencies do. This happens often because CDS traders are adjusting prices to incorporate information faster than rating agencies. From Reuters:

California’s latest monthly revenue report shows revenue weaker than expected even before the stock market, a key source of revenue for the state, began sliding in response to Standard & Poor’s downgrade of U.S. debt, anxiety about Europe’s finances and the risk of the U.S. economy slipping back into recession.

For officials in California’s capital, underwhelming July revenue and Wall Street’s hard times suggest they will have to draw up plans for cutting more spending early next year.

In a transparent market we should see more convergence between ratings and CDS, especially as CDS products are moved onto exchanges and away from trading in the over-the-counter markets. It’s a positive outcome that is rarely mentioned in debates about Dodd-Frank. Maybe when it happens highly paid bond market participants will stop complaining about divergence. Now that would be a positive.