The basic mechanics of the credit rating relationship are simple. After seeking bids from rating agencies, a municipal borrower selects a winning bid and the successful agency undertakes an evaluation of the borrower’s creditworthiness. The process of this evaluation is ultimately quite subjective. A borrower’s existing debt levels and ability to repay debt obligations may be gleaned from a balance sheet, but a borrower’s historical and prospective inclination to repay debt is a judgment call. Accordingly, there isn’t – and there shouldn’t be – a standard calculation that’s applied uniformly in evaluating creditworthiness.
This subjectivity creates a number of difficult questions for investors. Who made the judgment call? What is their level of experience? Their methodology? Are all assessments reached at in a similar fashion? In the “black-box” world of credit rating agencies, investors get free but often opaque answers. Further, that free knowledge comes without recourse if a rating turns out to be faulty. The agencies argue that they cannot be held accountable for the accuracy of a rating because it is an opinion—and thus protected by the First Amendment to the U.S. Constitution.
The degree to which these “opinions” permeate financial systems in the United States and beyond is immense. Among the provisions of the federal Fraud and Enforcement Recovery Act of 2009 was the creation of the Federal Crisis Inquiry Commission, which on September 17, 2009, commenced its investigation into the causes of the U.S. financial crisis between 2007 and 2010. One of the Commission’s statutory mandates was: “To examine the causes of the current financial and economic crisis in the United States … specifically the role of credit rating agencies in the financial system, including reliance on credit ratings by financial institutions and federal financial regulators, the use of credit ratings in financial regulation, and the use of credit ratings in the securitization markets…”.
In January 2011, following numerous hearings conducted over the previous 2 years, the Commission reported its findings. Concluding that Standard and Poor’s, Fitch Publishing Company and Moody’s Investors Service credit ratings were central to the financial crisis, the final report states, in part: “We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.”
Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates, or an expectation of rising interest rates in the near future, will cause the values of a Fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at, or near, historic lows. When interest rates rise, bond prices fall and a fund’s share price can fall. Municipal bonds are subject to default on income and principal payments. Further, a portion of some funds’ distributions may be taxable and may increase alternative minimum tax (AMT) for investors subject to that tax; distributions from net realized capital gains are taxable as capital gains. The funds invest in below-investment-grade debt securities, which may entail greater credit risks, as described in each fund’s prospectus. These securities (sometimes called “junk bonds”) may be subject to greater price fluctuations and risks of loss of income and principal than investment-grade municipal securities. The funds may invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. The funds may also invest substantially in Puerto Rico and other U.S. territories, commonwealths and possessions, and could be exposed to their local political and economic conditions.
Deterioration of the Puerto Rican economy could have an adverse impact on Puerto Rican bonds and the performance of the Rochester municipal funds that hold them.