Municipal bonds are rated by independent credit rating agencies that grade an issuer’s ability to repay on a letter scale running from AAA at the top down into speculative territory. The three agencies that dominate the market, Moody’s Investors Service, S&P Global Ratings, and Fitch Ratings, each apply their own scorecard: for general obligation bonds they weigh the local economy, financial performance, debt and pension burden, and governance; for revenue bonds they focus on whether the project’s income covers debt payments with room to spare. The final grade drives what the municipality pays to borrow and tells investors how much default risk they are taking.
Who Assigns the Ratings
Three firms handle the overwhelming majority of municipal ratings: Moody’s, S&P, and Fitch. All three are registered with the Securities and Exchange Commission as Nationally Recognized Statistical Rating Organizations, a status created by the Credit Rating Agency Reform Act of 2006 that brings them under federal oversight.1U.S. Securities and Exchange Commission. Current NRSROs The SEC’s registered list also includes smaller firms like Kroll Bond Rating Agency and DBRS, which rate some municipal deals.
Each agency runs its own methodology and analytical staff, so two agencies can land on slightly different grades for the same bond. The gap is usually small for strong credits and wider on the edges of investment grade. Larger issuers often buy ratings from two agencies to give investors a second read; smaller issuers sometimes use just one.
Ratings are paid for by the issuer, not by investors. Issuer fees account for roughly 90 to 95 percent of agency revenue, a setup known as the issuer-pay model. Congress addressed the built-in conflict through the 2006 reform act and later through Dodd-Frank provisions requiring the SEC to write rules on sales practices, internal controls, and analyst independence.2U.S. Securities and Exchange Commission. Credit Rating Agencies – Dodd-Frank Act Rulemaking
What the Letter Grades Mean
Every scale splits into two zones. Investment grade sits at or above BBB- for S&P and Fitch, and Baa3 for Moody’s. Anything below that line is speculative, sometimes called junk, and carries meaningfully higher default risk.3Municipal Securities Rulemaking Board. Credit Rating Basics for Municipal Bonds on EMMA
S&P and Fitch use identical letter symbols with plus and minus modifiers. AA+ is stronger than AA, and AA is stronger than AA-. Moody’s uses the same idea with numeric modifiers instead: Aa1 is the strongest within the Aa range, Aa2 the middle, Aa3 the weakest. Those modifiers run through the Caa category.4Moody’s Investors Service. Moody’s US Municipal Bond Rating Scale The top rating (Aaa or AAA) stands alone with no modifier.
A rough side-by-side of the investment-grade tiers:
- Highest quality: Moody’s Aaa; S&P AAA; Fitch AAA.
- High quality: Moody’s Aa1 through Aa3; S&P AA+ through AA-; Fitch AA+ through AA-.
- Upper-medium grade: Moody’s A1 through A3; S&P A+ through A-; Fitch A+ through A-.
- Lower-medium grade: Moody’s Baa1 through Baa3; S&P BBB+ through BBB-; Fitch BBB+ through BBB-.
Below that, borrowing costs jump sharply, and many institutional investors are barred by their own mandates from holding the bonds at all.
Outlooks and Watch Placements
A rating on its own is a snapshot. Agencies pair it with forward-looking signals. S&P assigns a “Rating Outlook” reflecting where analysts think the rating may head over the intermediate term, generally up to two years for investment-grade bonds and up to one year for speculative-grade bonds. An outlook (positive, negative, stable, or developing) is assigned when analysts see at least a one-in-three chance of a rating change over that window.5S&P Global Ratings. General Criteria: Use of CreditWatch and Outlooks
“CreditWatch” is more urgent. S&P uses it when a specific event creates at least a one-in-two chance of a rating change within 90 days: a sudden revenue collapse, a legal ruling, a governance crisis. The regular outlook is suspended while a bond sits on CreditWatch.5S&P Global Ratings. General Criteria: Use of CreditWatch and Outlooks Moody’s and Fitch run similar systems under different labels. The logic is the same across all three: outlooks flag gradual drift, watch placements flag a near-term event.
What Analysts Look At for General Obligation Bonds
General obligation bonds are backed by the issuer’s full taxing authority, so the rating reflects overall financial strength rather than any single revenue stream. Moody’s publishes a scorecard for cities and counties that divides the analysis into four weighted categories, and the framework is a good window into what actually drives the grade.
- Economy, 30 percent weight. Median household income compared to the national figure, full property value per capita, and local GDP growth against the national average. A diversified employer base with no single company dominating the tax rolls helps.
- Financial performance, 30 percent weight. Available fund balance as a share of revenue (the rainy-day reserve) and unrestricted cash relative to revenue. Analysts often benchmark against at least 60 to 90 days of cash on hand.
- Leverage, 30 percent weight. Total long-term liabilities divided by revenue, including debt, adjusted net pension liability, and net retiree healthcare obligations. A separate fixed-costs ratio captures annual debt service and pension contributions as a share of revenue.
- Institutional framework, 10 percent weight. A qualitative read on the legal and governance environment: state fiscal rules, home-rule authority, and the quality of financial management practices like multi-year budgeting and formal reserve policies.
S&P and Fitch use broadly similar frameworks under their own labels and weights, but the underlying questions match: how strong is the local economy, how well does the government manage cash, and how sustainable are its long-term obligations?
Pensions get particular scrutiny. Rating agencies run pension liabilities through their own models rather than accepting the numbers reported under Government Accounting Standards Board rules at face value.6GASB. Summary of Statement No. 68 Moody’s, for instance, applies its own discount rate assumptions to recalculate the liability independently. A city with a large unfunded pension gap that isn’t making adequate contributions will see that reflected in leverage regardless of how its audited statements present the figures.
How Revenue Bond Ratings Are Different
Revenue bonds are a different animal. They aren’t backed by the government’s taxing power; they depend on the income of a specific enterprise like a water utility, toll road, airport, or hospital. The rating reflects that operation’s finances, not the broader government’s.
The central metric is the debt service coverage ratio: annual net revenue from the project divided by annual debt payments. A ratio of 1.25x means the project earns 25 percent more than it owes bondholders each year. That figure often appears in the bond indenture as a legal covenant, and stronger credits routinely clear 1.5x or higher. Falling below the covenant triggers remedies written into the indenture, which might include hiring a consultant, raising rates, or restricting spending.
Indentures also usually require a debt service reserve fund, often sized at a year’s worth of payments, to cushion temporary revenue dips. Analysts read the legal protections in these documents alongside the operating fundamentals, because the strongest revenue stream doesn’t help if other parties can drain it before bondholders are paid.
How the Rating Process Runs
A municipality preparing a bond sale typically engages one or two agencies well before the bonds go to market. The issuer sends over several years of audited financial statements, current and projected budgets, capital improvement plans, and data on the local economy. For revenue bonds, the package adds operating statements for the specific enterprise and a copy of the bond indenture.
Analysts then meet with local officials to test areas the numbers alone can’t answer. How does the city plan to address a growing pension shortfall? What happens to the utility’s revenue if a major industrial customer leaves? How is the county funding deferred infrastructure work? Those conversations often say more about management quality than any single ratio.
Once the analyst writes an internal report, a rating committee votes on the grade. The committee structure exists specifically so no single analyst’s judgment determines the outcome. After publication, the agency keeps the bond under surveillance, reviewing financial updates at least annually and adjusting the rating or outlook when conditions warrant. A factory closure, a natural disaster, or a state policy change can all prompt a mid-cycle review.
What Ratings Actually Predict About Default
Municipal bonds have a very low historical default rate, and that context matters when reading a grade. Between 1970 and 2022, investment-grade municipal bonds carried a five-year cumulative default rate of just 0.04 percent, versus 0.87 percent for investment-grade corporate bonds. Even at Baa, the lowest investment-grade tier, munis defaulted at 0.44 percent over five years, compared with 1.47 percent for equivalent corporates.
Below investment grade, the numbers rise fast. Speculative-grade municipal bonds defaulted at a five-year rate of 4.63 percent, and B-rated munis at 11.74 percent. Ratings do sort risk in the municipal market, but the baseline for investment-grade munis is genuinely low.
What a Downgrade Does
A downgrade hits an issuer in two places at once. On future borrowing, each notch pushes interest costs up. Research has estimated roughly six basis points of added yield per notch in the investment-grade range. On a $100 million, 20-year issue, that adds up.
For bonds already in the secondary market, a downgrade tends to push prices down and widen the spread between what buyers will pay and what sellers want. Recently downgraded bonds carry greater liquidity risk, so investors trying to sell may have to accept a steeper discount.7MSRB. Municipal Bond Investment Risks The damage compounds if the downgrade crosses the investment-grade line, because many institutional investors and mutual funds are required to sell bonds that fall below BBB- or Baa3, dumping supply on the market at the worst moment.
Credit Enhancements That Change the Rating
An issuer doesn’t always have to live with its standalone grade. Credit enhancements let it borrow at rates closer to a stronger credit’s. The most familiar version is bond insurance: an insurance company guarantees principal and interest, and if the insurer’s rating is higher than the issuer’s, the bond trades at the insurer’s grade.
Insurance was more valuable before 2008, when the major insurers held Aaa ratings. After the financial crisis stripped several insurers of their top marks, the wrap became less useful for higher-rated issuers. It still helps lower-investment-grade and smaller issuers, where yield savings clear the premium cost.
State-level programs offer another path. A state aid intercept lets the state redirect aid owed to a school district or local government straight to bondholders if the issuer misses a payment. Programs of that kind exist in roughly 14 states and typically rate a few notches below the state itself. Direct state guarantees and permanent-fund pledges can push the enhanced rating even closer to the state’s level.
Unrated Municipal Bonds
Not every municipal bond carries a rating. Roughly 34 percent of local municipal bond offerings between 1998 and 2017 came to market unrated, though these were generally smaller deals, accounting for about 14 percent of total dollar volume. An unrated bond isn’t automatically risky, but the investor takes on more work: no professional credit analysis, no ongoing surveillance, and no shorthand for comparing the bond against peers. The market prices that gap into higher yields. Historically, unrated bonds have defaulted at roughly double the rate of rated bonds, which is consistent with the concern that some issuers skip a rating precisely because they expect a weak one.8FDIC. Do Municipalities Pay More to Issue Unrated Bonds?
Where To Look Up a Bond’s Rating
The Municipal Securities Rulemaking Board runs a free public site called EMMA (Electronic Municipal Market Access) that shows credit ratings, official financial disclosures, and trade data for nearly every municipal bond in the market.9Investor.gov. Using EMMA – Researching Municipal Securities and 529 EMMA pulls ratings from Moody’s, S&P, Fitch, and Kroll, so you can see where the agencies agree and where they don’t.3Municipal Securities Rulemaking Board. Credit Rating Basics for Municipal Bonds on EMMA If you’re buying individual municipal bonds rather than a fund, a check on EMMA is the minimum diligence before you commit.