The Economics of Municipal Bonds Discrimination : the Forces Behind Recalibration of 2010

Credit ratings are pivotal for municipal bonds as they determine borrowing cost for state and local level governments that are ultimately born by taxpayers. Prior to 2010 credit rating recalibration, municipal bonds were rated by major credit ratings agencies on a separate rating scale that resulted in the ratings that were significantly below the corporate bonds with similar credit risk. As a result, municipalities had to offer higher yields to investors or pay for bond insurance that drove cost of borrowing up. The objective of this paper is three-fold. Firstly, I survey current theoretical and empirical literature and show how various models (developed for other asset classes) can be applied to municipal bond market to explain why municipal debt had been underrated for decades. Secondly, I provide a comprehensive analysis of the political and economic forces that prompted credit rating agencies to upgrade (“recalibrate”) municipal bond ratings in the spring 2010. Thirdly, I document the process of recalibration as implemented by each credit rating agency. This paper can be used to set up event studies to broad our understanding of the municipal market, determinants of bond yields, borrowing costs, investors’ behavior and to inform contemporary public policy decision-making