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How Did That Bond Become AAA-Rated?

You Ought to Ask

Did you know that all AAA bonds are not the same? Some bonds may have achieved their AAA status through a “credit enhancement”; for example, something like an escrow account backing a bond issue, or collateral, such as a Government National Mortgage Association (GNMA or “Ginnie Mae) bond, or a bank-issued certificate of deposit (CD). The AAA rating of a bond may not be based on the creditworthiness of the issuing municipality. What does this mean to an investor? If you are an investor who seeks the very safest of investments, it’s important to know how a bond achieved its AAA rating and the creditworthiness of the “payor of last resort,” that is, what entity provided the final principal backing. Also, if you are confused about why one AAA-rated bond offers a higher yield than another, you may find that the reason is tied to how the AAA was achieved.

The Safest Credit Enhancement

The safest municipal bonds are those that are Escrowed to Maturity (ETM) or Pre-refunded. These bonds are backed dollar-for-dollar by U.S. Treasury securities for both principal and interest.

  • An escrowed bond is one for which the issuer has set aside U.S. Treasury securities in an amount equal to the bond’s total principal and interest payments through maturity of the issue.
  • A pre-refunded bond is one that will definitely be called on its first stated call date. U.S. Treasury securities in an amount totaling principal and interest up to the call date and including the call price have been set aside to “fund the call.”

Other Types of Enhancements

Municipal bonds that are AAA-rated based on some form of direct collateral other than U.S. Treasuries can be tricky. For example, a bond that is collateralized by a CD does not carry the full faith and credit guarantee of the U.S. Treasury as to timely payment of principal and interest like one backed by a GNMA, for instance. A AAA-rated bond backed by a CD is backed by the bank issuing the CD and, in the event of the bank’s default, by the government agency that insures banking institutions. The creditworthiness of a Congressionally budgeted government agency, such as the FDIC, is not the same creditworthiness that is offered by agencies with guarantees that are direct obligations of the U.S. Treasury, as is the case of GNMA or Strips or U.S. Trust Certificates.

Banks also become the payor of last resort when the bonds are backed by Letters of Credit (LOC). The creditworthiness of the bank issuing the LOC is subject to change with the financial well-being of the bank. If the bank is down-rated, the muni bond supported by its LOC is also down-rated, despite the status of the municipality. In the event of a municipal default, the bank is the payor of last resort. Investors should note that foreign bank LOCs are frequently issued by their U.S. subsidiaries, and it may be that there is no recourse to the parent foreign bank in the event of financial difficulty.

Similarly, there are implied AAA-rated bonds with indirect government backing from agencies like the Federal Housing Administration (FHA) or Federal National Mortgage Association (FNMA). The agencies have a perceived tie to the federal government as institutions established under federal legislation but carry greater risk than those guaranteed by the U.S. government. Since September 2008, the Federal Housing Financial Agency became the conservator of the two housing mortgage insurance agencies: FNMA and FHLMC. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of the agencies. While no agency has ever failed to fulfill its guarantee, no law or contract prohibits it from doing so. In any case, practically all government agencies have an implied AAA rating regardless of their financial health.

Municipalities and Municipal Bond Insurance Companies

Some municipalities are so financially strong that their bonds are issued with AA+ or AAA rating without any credit enhancement. As typical in the risk-reward equation, these bonds are regarded as more secure than those underwritten with municipal bond insurance and offer lower yields than insured bonds.

Last in your investigation of the origins of a bond’s AAA rating is the insured bond. With municipal bond insurance, it’s even possible to buy a AAA-rated bond from a municipality that is actually bankrupt! No insurance company yet has been put to the test with an overwhelming amount of simultaneous municipal bond defaults, though in 2008 some municipal bond insurance companies did experience severe downgrades in their AAA-rating due to losses in their non-municipal bond insurance areas. Nevertheless, bonds that carry AAA-rated municipal bond insurance, despite their underlying municipality’s rating, carry the same AAA-rating as bonds backed by U.S. Treasury securities.

Clearly, the degree of risk with any AAA-rated bond is nominal compared with a lesser rated bond. But, if ultimate security is your goal in muni bond investing, take a moment to ask how that bond earned its AAA grades.

If your portfolio is greater than $500,000, Sharon Alister can provide a free analytic review to help ensure that your portfolio is in line with your investment goals. Call Sharon Alister at (800) 745-7110 or email info@AlisterTalksBonds.com

 

Interest Rates (Indications only)

Please note the rates for Ins’d and Pre-Res are not available from Bloomberg and will be updated as soon as possible.

Treasuries AAA Munis
3mo 1.815 N/A
6mo 2.009 N/A
1yr 2.237 1.74
2yr 2.482 1.87
5yr 2.809 2.19
10yr 2.970 2.53
30yr 3.145 3.14
today's rates chart

AAA Rated Munis

Pre-Res Ins’d Pure*
2 yr 1.91 2.05 1.87
5 yr 2.23 2.49 2.19
10 yr N/A 2.89 2.53
15 yr N/A 3.20 2.82
30 yr N/A 3.50 3.14

*Rated AAA on its own
Source: Bloomberg

How Did That Bond Become AAA-Rated?

You Ought to Ask

Did you know that all AAA bonds are not the same? Some bonds may have achieved their AAA status through a “credit enhancement”; for example, something like an escrow account backing a bond issue, or collateral, such as a Government National Mortgage Association (GNMA or “Ginnie Mae) bond, or a bank-issued certificate of deposit (CD). The AAA rating of a bond may not be based on the creditworthiness of the issuing municipality. What does this mean to an investor? If you are an investor who seeks the very safest of investments, it’s important to know how a bond achieved its AAA rating and the creditworthiness of the “payor of last resort,” that is, what entity provided the final principal backing. Also, if you are confused about why one AAA-rated bond offers a higher yield than another, you may find that the reason is tied to how the AAA was achieved.

The Safest Credit Enhancement

The safest municipal bonds are those that are Escrowed to Maturity (ETM) or Pre-refunded. These bonds are backed dollar-for-dollar by U.S. Treasury securities for both principal and interest.

  • An escrowed bond is one for which the issuer has set aside U.S. Treasury securities in an amount equal to the bond’s total principal and interest payments through maturity of the issue.
  • A pre-refunded bond is one that will definitely be called on its first stated call date. U.S. Treasury securities in an amount totaling principal and interest up to the call date and including the call price have been set aside to “fund the call.”

Other Types of Enhancements

Municipal bonds that are AAA-rated based on some form of direct collateral other than U.S. Treasuries can be tricky. For example, a bond that is collateralized by a CD does not carry the full faith and credit guarantee of the U.S. Treasury as to timely payment of principal and interest like one backed by a GNMA, for instance. A AAA-rated bond backed by a CD is backed by the bank issuing the CD and, in the event of the bank’s default, by the government agency that insures banking institutions. The creditworthiness of a Congressionally budgeted government agency, such as the FDIC, is not the same creditworthiness that is offered by agencies with guarantees that are direct obligations of the U.S. Treasury, as is the case of GNMA or Strips or U.S. Trust Certificates.

Banks also become the payor of last resort when the bonds are backed by Letters of Credit (LOC). The creditworthiness of the bank issuing the LOC is subject to change with the financial well-being of the bank. If the bank is down-rated, the muni bond supported by its LOC is also down-rated, despite the status of the municipality. In the event of a municipal default, the bank is the payor of last resort. Investors should note that foreign bank LOCs are frequently issued by their U.S. subsidiaries, and it may be that there is no recourse to the parent foreign bank in the event of financial difficulty.

Similarly, there are implied AAA-rated bonds with indirect government backing from agencies like the Federal Housing Administration (FHA) or Federal National Mortgage Association (FNMA). The agencies have a perceived tie to the federal government as institutions established under federal legislation but carry greater risk than those guaranteed by the U.S. government. Since September 2008, the Federal Housing Financial Agency became the conservator of the two housing mortgage insurance agencies: FNMA and FHLMC. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of the agencies. While no agency has ever failed to fulfill its guarantee, no law or contract prohibits it from doing so. In any case, practically all government agencies have an implied AAA rating regardless of their financial health.

Municipalities and Municipal Bond Insurance Companies

Some municipalities are so financially strong that their bonds are issued with AA+ or AAA rating without any credit enhancement. As typical in the risk-reward equation, these bonds are regarded as more secure than those underwritten with municipal bond insurance and offer lower yields than insured bonds.

Last in your investigation of the origins of a bond’s AAA rating is the insured bond. With municipal bond insurance, it’s even possible to buy a AAA-rated bond from a municipality that is actually bankrupt! No insurance company yet has been put to the test with an overwhelming amount of simultaneous municipal bond defaults, though in 2008 some municipal bond insurance companies did experience severe downgrades in their AAA-rating due to losses in their non-municipal bond insurance areas. Nevertheless, bonds that carry AAA-rated municipal bond insurance, despite their underlying municipality’s rating, carry the same AAA-rating as bonds backed by U.S. Treasury securities.

Clearly, the degree of risk with any AAA-rated bond is nominal compared with a lesser rated bond. But, if ultimate security is your goal in muni bond investing, take a moment to ask how that bond earned its AAA grades.

If your portfolio is greater than $500,000, Sharon Alister can provide a free analytic review to help ensure that your portfolio is in line with your investment goals. Call Sharon Alister at (800) 745-7110 or email info@AlisterTalksBonds.com

 

Interest Rates (Indications only)

Please note the rates for Ins’d and Pre-Res are not available from Bloomberg and will be updated as soon as possible.

Treasuries AAA Munis
3mo 1.815 N/A
6mo 2.009 N/A
1yr 2.237 1.74
2yr 2.482 1.87
5yr 2.809 2.19
10yr 2.970 2.53
30yr 3.145 3.14
today's rates chart

AAA Rated Munis

Pre-Res Ins’d Pure*
2 yr 1.91 2.05 1.87
5 yr 2.23 2.49 2.19
10 yr N/A 2.89 2.53
15 yr N/A 3.20 2.82
30 yr N/A 3.50 3.14

*Rated AAA on its own
Source: Bloomberg

Investing involves risk, including possible loss of principal. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. Conversely, as interest rates fall, bond prices will rise.

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