By Chris Toney, Director and Todd Alton, Vice President, Credit Research
Mitigating Rating Agency Risk for LGIP Services
Here we are, over a half-decade removed from The Great Recession, the second greatest financial calamity in our country’s history. Much has changed, and will continue to change. In our opinion, the fall-out will continue to reverberate for years to come, just as the Great Depression defined a prior generation’s financial regulation, e.g., the Securities Act of 1933, the creation of the Securities and Exchange Commission, and the Investment Company Act of 1940. To our frequent readers, you may recall that we at Public Trust Advisors have recently written of both the intended and unintended impacts of the Dodd-Frank Wall Street Reform and Consumer Protection Act, this generation’s hallmark financial regulation affecting the financial services industry and public funds investing.
One of the least discussed aspects of both Dodd-Frank and the credit crisis are the impacts made to the Nationally Recognized Statistical Rating Organizations (NRSRO). Post-recession, the NRSROs are now held to a higher standard and their reputations are under more scrutiny than ever before. In our opinion, these events have led the NRSROs to err on the side of caution, resulting in a far greater number of negative outlooks and ratings downgrades for corporations and governments alike.
The Public Trust Advisors Perspective
Currently, Public Trust Advisors manages a number of local government investment pool (LGIP) portfolios which are rated AAAm by Standard & Poor’s and in order to maintain these ratings the portfolios must contain securities rated in the highest rating categories by Standard & Poor’s. Essential to maintaining the AAAm ratings, Public Trust Advisors in our role as Investment Advisor, is keenly aware of this situation and vigilant toward any possible negative rating actions.
For Public Trust, the greatest concern is not the default of a credit in the portfolio. The greatest concern is rating agency or NRSRO risk. So what is “rating agency risk?” Rating agency risk is the risk that an issuer is suddenly downgraded by one of the NRSROs to a level below the highest rating category. This scenario could force portfolio management to sell a security at an inopportune time when the pricing of the security would most likely be negatively impacted due to a rating agency downgrade.
Monitoring Change; Avoiding Downgrades
To avoid possible downgrade scenarios, the Public Trust credit team is diligent with regards to headlines and market signals related to the approved issuers for its portfolios. Daily monitoring through Bloomberg provides any rating change, including negative outlooks or watches that portend possible downgrades.
For example, in recent years several “pillar banks” (global money center banks) have enjoyed the highest credit ratings (A-1+ short-term ratings), due largely to their ability to avoid many of the pitfalls during the global financial crisis. In our opinion, some of their success can be attributed to heavy reliance on commodity based economies, specifically energy, oil and mining, since these industries experienced growth and price appreciation while other industries, such as the mortgage market were facing decline.
In light of the recent collapse of commodity prices (namely crude oil) the rating agency opinions of these pillar banks with commodity exposure are evolving toward a more negative stance. The commodity-driven economies (e.g. Australia, Canada) are inevitably going to slow and the rating agencies are now more concerned about systemic support or lack thereof for the pillar banks.
As we monitor and contemplate these changes, the Public Trust credit and portfolio management teams have reduced our exposures to the pillar banks in order to mitigate the ratings agency risk associated with any potential downgrades. This involves reducing the hold times (hold codes) of these banks and performing higher due diligence around the sectors, and issues for each bank.
Whether it be an individual security or issuer, or ever-changing economic cycles, our foremost concern and commitment is focused on safeguarding the principal of the LGIP Participants by applying a higher standard of care through all of our actions.
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