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Mitigating Rating Agency Risk

FLCLASS - Mitigating Agency Risk

Next year, 2018, marks a decade since 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. 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) are often a subject of discussion.

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 FLCLASS Perspective

Currently, the FLCLASS portfolio is rated ‘AAAm’ by S&P Global Ratings. To maintain this rating, a portfolio must contain securities rated in the highest rating categories by S&P. The FLCLASS Governing Board in conjunction with the Investment Advisor, Public Trust Advisors, LLC (Public Trust), work vigilantly towards mitigating 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. 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 insurers for the FLCLASS portfolio. Daily monitoring through Bloomberg of all FLCLASS approved issuers provides any rating change, including negative outlooks or watches that portend possible downgrades.

In recent years, for example, 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.

As we monitor and contemplate these changes, the Public Trust credit and portfolio management teams have reduced our exposures to the pillar banks to mitigate the rating 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 issuers for each bank.

Whether it be an individual security, issuer, or ever-changing economic cycles, our foremost concern and commitment are focused on safeguarding the principal of the FLCLASS Participants by applying a higher standard of care in all of our actions.

A ‘AAAm’ rating by S&P Global Ratings is obtained after S&P evaluates a number of factors including credit quality, market price exposure, and management. Ratings are subject to change and do not remove credit risk.
All comments and discussions presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is no guarantee of future results. Any financial and/or investment decision may incur losses.