S&P - Public Finance Criteria (2007). - The Global Clearinghouse

Assessing Construction RiskInterest rate/option riskInterest-rate risk refers to the fact that the longerthe maturity of a security, the more uncertain andtherefore more risky the present value of its cashflows. Securities with an uncertain maturity, suchas, callable securities, or securities with embeddedoptions (e.g., like mortgage-backed bonds) are bynature riskier than those with a known maturity. Inaddition, the distribution of a security or a fund’scash flows along the maturity spectrum (or yieldcurve) is as relevant as the maturity itself. A bond’s(or pool’s) interest-rate risk is best measured by itsduration. Duration approximates the overall pricesensitivity of the portfolio to changes in interestrates. Duration is a more precise measure of interestrate risk than maturity because it takes into accountall of the bond’s cash flows. For example, whenrates rise by one half of 1% (or 50 basis points),the value of a pool with a duration of four yearswill decrease by about 2%.Credit and liquidity risksCredit and liquidity risks are distinct, althoughoften closely related. Credit risk refers to the possibilitythat an issuer may become unable or unwillingto meet its payment obligations on time or infull. Securities with higher credit risk trade on higheryields compared to lower credit risk securities,and the variations in such yield spreads are oftendescribed as spread risk. Liquidity risk refers to thepossible price penalty incurred when buying or sellinga particular security or asset for which there is alimited secondary market. Liquidity is also measuredby how quickly a security can be sold.Standard & Poor’s considers the effects of theserisks, among others, when evaluating the overallprice sensitivity of a fund. The relevant risk is theaggregate risk, measured after all diversificationbenefits are taken into account.Management assessmentFund manager assessment is an opportunity forStandard & Poor’s to gain an in-depth understandingof different factors that could affect a fund’soverall risk profile. Since fund managers can have asignificant impact on the fund’s future risk profile,Standard & Poor’s meets with fund managers todiscuss various portfolio risk related topics. Atthese meetings, Standard & Poor’s looks at managementsophistication and experience, the qualityof research support, dedication to controlling riskwithin established guidelines, portfolio strategies,and the frequency and extent of changes to portfolioholdings, among other factors. Even after a fundis rated, Standard & Poor’s meets with the fundmanagers at least annually.Credibility and commitment to policiesStandard & Poor’s judges each fund and its managementon its own merits. There is no ‘model’fund. Whether a fund has a retail or institutionalshareholder base, or favors an aggressive investmentapproach over a conservative strategy is notcritical. The important issue is how the fund ismanaged. Policies and strategies may differ fromfund to fund, but the degree to which managementhas control over them should not. Standard &Poor’s closely examines the daily operations of thefund, including organizational structure and depth,the degree of oversight and accountability, particularlyin the portfolio and risk management areas. ■Assessing Construction RiskConstruction risk is present in virtually all publicfinance transactions, but it typically introducescredit risk only in those transactions where debtservice payment is contingent on project completionand/or acceptance. Standard & Poor’s RatingsServices addresses construction risk directly in therating, either through an evaluation of the constructionprocess or, with credit support such as lettersof credit during the construction period. The depthof the evaluation of the construction process willvary by project; earthquake analysis is unchanged.For example, the analysis performed on a schoolbuilding will be less than that performed on an offcampusstudent housing project.Standard & Poor’s will adopt a continuum ofrisk approach to assessing construction risk. If thereis strong public support for a project, and the projectsare not complex, the construction analysis willfocus on the following issues:■ Project essentiality;■ Experience with similar projects;■ Contractor’s experience with the issuer/obligor;■ Project schedule and cost structure;■ Construction contingencies in the project budget;www.standardandpoors.com323