http://www.standardandpoors.com 323Interest rate/option risk
Interest-rate risk refers to the fact that the longer
the maturity of a security, the more uncertain and
therefore more risky the present value of its cash
flows. Securities with an uncertain maturity, such
as, callable securities, or securities with embedded
options (e.g., like mortgage-backed bonds) are by
nature riskier than those with a known maturity. In
addition, the distribution of a security or a fund’s
cash flows along the maturity spectrum (or yield
curve) is as relevant as the maturity itself. A bond’s
(or pool’s) interest-rate risk is best measured by its
duration. Duration approximates the overall price
sensitivity of the portfolio to changes in interest
rates. Duration is a more precise measure of interest
rate risk than maturity because it takes into account
all of the bond’s cash flows. For example, when
rates rise by one half of 1% (or 50 basis points),
the value of a pool with a duration of four years
will decrease by about 2%.
Credit and liquidity risks
Credit and liquidity risks are distinct, although
often closely related. Credit risk refers to the possi-
bility that an issuer may become unable or unwill-
ing to meet its payment obligations on time or in
full. Securities with higher credit risk trade on high-
er yields compared to lower credit risk securities,
and the variations in such yield spreads are often
described as spread risk. Liquidity risk refers to the
possible price penalty incurred when buying or sell-
ing a particular security or asset for which there is a
limited secondary market. Liquidity is also meas-
ured by how quickly a security can be sold.
Standard & Poor’s considers the effects of theserisks, among others, when evaluating the overall
price sensitivity of a fund. The relevant risk is the
aggregate risk, measured after all diversification
benefits are taken into account.
Management assessment
Fund manager assessment is an opportunity for
Standard & Poor’s to gain an in-depth understand-
ing of different factors that could affect a fund’s
overall risk profile. Since fund managers can have a
significant impact on the fund’s future risk profile,
Standard & Poor’s meets with fund managers to
discuss various portfolio risk related topics. At
these meetings, Standard & Poor’s looks at man-
agement sophistication and experience, the quality
of research support, dedication to controlling risk
within established guidelines, portfolio strategies,
and the frequency and extent of changes to portfo-
lio holdings, among other factors. Even after a fund
is rated, Standard & Poor’s meets with the fund
managers at least annually.
Credibility and commitment to policies
Standard & Poor’s judges each fund and its man-
agement on its own merits. There is no ‘model’
fund. Whether a fund has a retail or institutional
shareholder base, or favors an aggressive invest-
ment approach over a conservative strategy is not
critical. The important issue is how the fund is
managed. Policies and strategies may differ from
fund to fund, but the degree to which management
has control over them should not. Standard &
Poor’s closely examines the daily operations of the
fund, including organizational structure and depth,
the degree of oversight and accountability, particu-
larly in the portfolio and risk management areas.■Assessing Construction Risk ............................................................................................
C
onstruction risk is present in virtually all public
finance transactions, but it typically introduces
credit risk only in those transactions where debt
service payment is contingent on project completion
and/or acceptance. Standard & Poor’s Ratings
Services addresses construction risk directly in the
rating, either through an evaluation of the construc-
tion process or, with credit support such as letters
of credit during the construction period. The depth
of the evaluation of the construction process will
vary by project; earthquake analysis is unchanged.
For example, the analysis performed on a schoolbuilding will be less than that performed on an off-
campus student housing project.
Standard & Poor’s will adopt a continuum of
risk approach to assessing construction risk. If there
is strong public support for a project, and the proj-
ects are not complex, the construction analysis will
focus 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;