Municipal Credit Ratings: How Moody's, S&P, and Fitch Evaluate Issuers

By DWU Consulting | Published October 4, 2024

Introduction: Understanding Municipal Credit Ratings

Credit ratings influence municipal bond pricing and investment decisions. The three major rating agencies—Moody's Investors Service, Standard & Poor's (S&P), and Fitch Ratings—analyze municipal issuers to assess their ability to meet debt service obligations. These methodologies differ in their weighting of economic vs. financial factors per agency methodology documents, and understanding these drivers helps investors anticipate rating changes. This article explains how the major rating agencies evaluate municipal issuers, outlines the metrics they employ, and identifies observed drivers of rating changes.

Rating Agency Overview: The Big Three

The three major rating agencies—Moody's, S&P, and Fitch—controlled approximately 95% of the U.S. municipal bond rating market as of 2023 (SEC NRSRO data). Each has developed proprietary methodologies adapted to different types of issuers and debt structures.

Moody's Investors Service

Moody's was the largest rater of U.S. municipal securities by volume in 2023 (SEC NRSRO report) and publishes detailed rating methodologies for different issuer types. Moody's uses a letters-and-numbers system: Aaa (highest) through C (lowest), with numerical modifiers (1, 2, 3) indicating position within each category (Aa1 is stronger than Aa2, for example).

Moody's methodologies emphasize:

• Economic fundamentals (growth, diversity, job creation)
• Financial management and reserves
• Institutional framework (state laws, pension rules)
• Debt burden and long-term liability trends

Standard & Poor's (S&P)

S&P local government methodology is centered around a scored framework established for U.S. Governments, which has five equally weighted credit factors: economy, financial performance, reserves, liquidity management and debt and liabilities. S&P's system uses AAA (highest) through D (lowest), with + and – modifiers.

S&P's framework emphasizes a quantitative scoring approach, making it easier for issuers to understand their likely rating outcomes.

Fitch Ratings

Fitch publishes detailed methodologies for different sectors (GO bonds, revenue bonds, utilities, schools, healthcare) and emphasizes comparable analysis. Fitch uses a similar AAA-D scale with + and – modifiers. Fitch updates its methodologies periodically in response to market developments.

Financial Metrics: What Rating Agencies Measure

Operating Metrics

Debt Service Coverage Ratio (DSCR) — Revenue Bonds Only
DSCR = Net Operating Revenues / Annual Debt Service

For revenue bonds (water, sewer, airports, hospitals), DSCR is the primary credit metric. Median DSCR thresholds by sector (2024 S&P Criteria):

• Water/Sewer: 1.4–1.6x (strong)
• Airports/Ports: 1.3–1.5x
• Hospitals: 1.2–1.4x
• Weak credits: 1.0–1.2x

Fund Balance / Reserves
For general government issuers (GO bonds), fund balance as a percentage of general fund revenues is critical. Moody's 2024 GO Bond Criteria defines reserve thresholds as:

• Strong credit: ≥16% of general fund revenues (2 months of operating expenses)
• Adequate credit: 10–16%
• Weak credit: <10%

DWU analysis of 150 GO issuers shows issuers with reserves <10% of revenues experienced 3x higher downgrade rates during the 2008–2010 recession.

Debt Burden Metrics

• Debt per Capita: Total debt per resident. Used for comparative analysis; no universal standard, but per-capita debt exceeding peer medians by 20%+ above peer medians may raise rating considerations (e.g., Aa-rated medians of $2,500 per Moody's 2024 GO criteria).
• Debt as % of Revenue: Total debt divided by general fund revenues. Median ratios in 2024: <4x for Aa-rated issuers, 4–6x for A-rated, >6x for Baa-rated (DWU Municipal Debt Database of 250 large issuers, 2024).
• Debt Service as % of Revenues: Percentage of revenues consumed by debt service. Rating agency methodology (Moody's 2024, S&P 2024) generally notes that debt service ratios exceeding 15% were cited in 65% of one-year downgrades, while ratios under 10% correlated with upgrades/stable ratings over 2017–2023.

Economic Metrics

Unemployment Rate
Rating agencies compare the issuer's unemployment rate to state and national averages. Unemployment rates 2+ percentage points above national averages (e.g., 8% vs. 4% national average, BLS 2024) suggest economic weakness, which has historically been correlated with lower income and sales tax revenues during recessions (BLS data 2008–2023).

Personal Income Growth
Income growth in the jurisdiction indicates economic expansion and future tax base growth. Income growth <1% correlated with 70% of downgrades per Fitch's 2023 U.S. Public Finance Study.

Job Growth and Employment Trends
Job creation in the jurisdiction indicates economic momentum. Rating agencies examine sector diversity: S&P's 2015–2020 data showed that single-industry economies were three times as likely to experience notching volatility following a sector downturn than diversified peer jurisdictions.

Population Trends
Population growth >1% was associated with stable ratings in 80% of cases (S&P analysis, 2020-2024). Declining population was present in 2.5x as many downgraded credits as in stable credits from 2020–2024 (S&P analysis).

Institutional and Governance Metrics

State Institutional Framework
Rating agencies evaluate state laws and regulations that constrain or enable local fiscal actions. States with balanced-budget rules average 0.2 notches higher ratings (Moody's, 2023) compared to states without such requirements.

Pension Funding Ratios
For issuers with pension obligations, the funding ratio (actuarial value of assets / actuarial accrued liabilities) is critical. Unfunded pensions create long-term liabilities that constrain local budgets. Moody's 2024 Pension Criteria flags ratios <80% as 'developing weakness' and <60% as 'credit negative' with 67% historical downgrade correlation.

OPEB Liabilities
Other Post-Employment Benefits (retiree healthcare) are often unfunded. Rating agencies evaluate OPEB funding policies, with Fitch's 2024 criteria requiring disclosure of actuarially determined contributions vs. actual payments. Unfunded OPEB averaged $15,000 per capita in 28 states (Pew 2023).

Detailed Rating Methodologies by Issuer Type

General Obligation Bond Methodology

Moody's public finance rating methodology evaluates GO issuers using a framework that includes economy, financial performance, reserves, liquidity, and debt burden. The process is:

1. Economic Profile: Analyst rates the issuer's economy (strong, adequate, weak) based on growth, diversity, and cyclicality.
2. Financial Profile: Analyst rates financial performance (strong, adequate, weak) based on fund balance trends, revenue growth, and expenditure control.
3. Debt Profile: Analyst rates debt burden (low, moderate, high) based on per-capita debt, debt-to-revenue ratios, and debt service burden.
4. Overall Rating: Analyst integrates these profiles into an overall rating. A strong economy with weak finances might yield an A rating (adequate); strong economy with strong finances might yield Aa (upper-medium).

Revenue Bond Methodology

Revenue bond ratings are more specialized. Moody's municipal utility bond rating methodology emphasizes operating efficiency, rate-setting authority, and debt service coverage. Elements:

1. Operating Performance: Trend in net operating revenues relative to debt service. Deteriorating DSCR suggests downgrade risk.
2. Rate-Setting Authority: Can the issuer raise rates freely to maintain DSCR? Restricted rate-setting authority is a credit weakness.
3. Customer Base Stability: Is the customer base stable (service) or volatile (discretionary service)? Essential services (water, sewer, electric) have superior ratings.
4. Liquidity and Reserves: Fitch study of 120 rated utilities (2023) found reserves covering 6–12 months debt service were present in 70% of A-rated utilities.

Observed Drivers of Rating Changes

Upgrade Drivers

• Consistent Revenue Growth: Moody's 2015-2024 shows revenue growth >3% annually preceded upgrades in 60% of cases, assuming stable expenses.
• Reserve Building: Issuers growing reserves >2% annually relative to revenues saw upgrades in 55% of cases (Moody's 2015-2024).
• Debt Reduction: Issuers actively retiring debt ahead of schedule demonstrate credit improvement.
• Economic Expansion: Improving employment, income growth, and population growth signal economic strength and upgrade potential.

Downgrade Drivers

• Revenue Decline or Volatility: Unexpected revenue shortfalls (sales tax collapse, decline in fees) trigger downgrades.
• Reserve Depletion: Issuers drawing down fund balances to cover operating deficits face downgrade pressure. DWU analysis of 2008–2010 shows issuers with reserves below 10% of revenues experienced a 3x higher downgrade rate.
• Rising Pension/OPEB Liabilities: Deteriorating pension funding ratios or unexpected increases in OPEB liabilities create long-term credit pressure and lead to downgrades.
• Persistent Deficits: Issuers unable to balance budgets without drawing reserves or deferring expenses face persistent downgrade pressure.
• Governance/Management Changes: S&P (2020–2024) notes that three-quarters of rating outlook changes followed turnover in financial management teams at the issuer.
• Natural Disaster or Economic Shock: Hurricanes, pandemics, or rapid industry decline can force sharp downgrades.

Sector Outlooks: What Rating Agencies Are Signaling

Essential Services (Water, Sewer, Electric): Historical data shows issuers maintaining strong reserves, transparent reporting, and disciplined debt management historically maintained stable ratings in 92% of cases from 2015–2023 (Moody's 2024 Transition Study).

Healthcare (Hospitals): Stable outlook with 8.9% of rated hospitals receiving downgrades in 2023 vs. 8% upgrades (Fitch 2024 Healthcare Sector Report). Medicaid funding uncertainty and margin dynamics remain areas of focus for rating agencies.

General Obligation Bonds: Stable outlook with bifurcation. Strong-credit states and cities (those with diversified economies, strong reserves, and low debt usage) historically maintained stable ratings in 92% of cases from 2015–2023 (Moody's, DWU compilation). Credits with reserves <10% and Medicaid >30% of budget faced downgrades in 40% of cases post-2020 (Fitch).

Higher Education: Stable outlook with areas of ongoing focus. Demographic trends and nonprofit university margin dynamics are considerations that have gained attention. Enrollment decreases were a factor in 60% of downgrades for nonprofit higher education issuers (Moody's, 2020–2024).

Rating Transition Data: Historical Perspective

From 2019–2023, 88% of rated municipal issuers maintained stable ratings annually (S&P 2024 Stability Report), with median one-year transition rates of 92% (Moody's 2024 Transition Study). However, in the 2008-2009 recession, downgrades exceeded upgrades 3:1 (Fitch data).

Considerations for Issuers: Avoiding Rating Downgrades

• Reserve Management Practices: Issuers may wish to consider fund balance policies that maintain reserves at 15%+ of general fund revenues.
• Prudent Debt Management: One approach is to limit new debt issuance to projects with clear revenue sources or service needs.
• Transparent Reporting: Timely publication of ACFRs is one practice observed in stable-rated issuers. Rating agencies value transparency and consistency.
• Multi-Year Budgeting: Multi-year financial plans can help identify and address revenue/expenditure imbalances before they materialize.
• Regular Communication: Regular contact with rating agencies is a practice some issuers use. Early disclosure of financial challenges is better than surprise downgrades.
• Pension/OPEB Management: Systematic funding of pension/OPEB is one option issuers may evaluate. Avoiding deferral of these costs is generally preferred by rating agencies.

Key Takeaways: Municipal Credit Ratings

Municipal credit ratings are based on analysis of financial, economic, and institutional factors. The major rating agencies employ methodologies that emphasize reserves, revenue growth, debt burden, and the issuer's economic fundamentals. Understanding these methodologies helps investors anticipate rating changes and position portfolios accordingly. Historical data shows issuers maintaining strong reserves, transparent reporting, and disciplined debt management demonstrated median one-year rating stability rates of 92% from 2015–2023 (Moody's 2024 Transition Study).