Felix Salmon is skeptical that there is a market demand for bond ratings the differentiate between various issuers. His skepticism, however, is built on a simplistic image of who invests in bonds. To Salmon, it seems that muni bond investors are mostly old ladies in tennis shoes who buy bonds when they aren’t protesting water fluoridation. With this image in mind, he simple can’t believe that there would be a market demand for muni bonds to be rated relative other muni bonds rather than corporate bonds.
Our response begins with the observation that the alternative is simply implausible. If there is no market demand for the relative rating of muni bonds, why on earth is it happening? Jesse Eisinger hints at some kind of grand conspiracy between the ratings agencies and bond insurers but doesn’t really have any evidence for this conspiracy other than the fact that because he rejects the idea—on some principal that’s never been articulated—that there’s a market demand for relative ratings, he think there must be a conspiracy. This is question begging and violates Occam’s razor.
What’s more, Salmon’s image of bond investors is inaccurate. They are a heterogeneous lot made up of households, mutual funds, pension funds and banks. Even if a good deal of the investors are uninformed, the demand by sophisticated investors at the margin is enough to create the demand for relative bond ratings. Many of these investors have been so sophisticated that they created a demand for services which provide them with the underlying ratings of muni bonds regardless of bond insurance. In short, muni bonds are not the simplistic retail customers Salmon thinks they are.
It may help to take a look at why muni investors require such granular credit analysis. The reason is relatively easy to understand: municipalities have far less and less consistent financial transparency than corporations, especially public corporations. We can see this in the different ways bond prices respond to ratings downgrades. In the publicly held corporate sector, bond prices often don’t move much after a ratings change because the ratings are late to the game. The information driving the ratings change is typically already reflected in the bond prices (as well as the stock price). But for municipalities the situation is very different. Without an equity market and free from many financial disclosure rules governing public companies, muni investors are dependent on the ratings agencies to discover information about the financial health of muni issuers. This makes muni investors far more focused on ratings showing small gradations in issuers health than corporate bond investors.