The value of municipal bond credit research is difficult to measure, particularly by any quantitative measure. Quite often, the value of credit research is not solely the extent to which it may add to performance, but the extent to which it may limit potential drags on performance.
Historically, individual investors and portfolio managers alike have relied heavily upon the credit reports published by the independent ratings agencies. While these reports can be enlightening and often revealing of the credits they review, they can also be confusing to investors. Of particular concern is the recent trend of upgrades versus downgrades, which is an indication of credit trends. Through the second quarter of 2014, Moody’s upgraded the credit ratings of 187 public finance entities and downgraded 3321 while Standard & Poor’s upgraded the credit ratings of 1,256 public finance entities and downgraded 4152. This can make it difficult for investors to compare bonds rated by different ratings agencies and confusing when a single bond is rated by both agencies but given two different credit ratings. As subadviser, our process is to prepare a detailed credit report which includes our independent rating for each of the holdings in the portfolio.
While investment performance is often attributed to a portfolio manager, the confidence to invest portfolio assets during times of fiscal crisis is enhanced by the work performed by the credit team. In addition, we have our own independently developed methodology that is driven by a credit committee that meets on a quarterly basis to discuss the decisions of the portfolio management team and focus the efforts of our credit research. In recent years both higher education and healthcare related financings have received specific attention from our credit committee. The results of our committee’s findings have not been to eliminate all such holdings for the sake of lowering risk, but rather to focus on those aspects of individual holdings which introduce risk, and eliminate holdings that expose the portfolio assets to specifically identified risks, rather than blindly selling bonds that might otherwise add to performance.
Timely decisions on credit quality are one of the many contributions of the credit analyst in assisting the portfolio manager as they seek to achieve the risk-adjusted performance objectives. However, it is through the combined efforts of portfolio management and credit analysis that we are able to execute some of our most effective trades. Recently, a healthcare credit fell below several of our key thresholds for this sector, which alerted our analyst to take a closer review of the credit and ultimately present it to portfolio management as a sale candidate. The portfolio manager determined current spread levels and valuations and was able to sell the bond on far more favorable terms than when the bond was acquired, even though the credit had deteriorated. This trade would not have been possible were it not for timely credit research and effective communication that allowed us to sell the bond prior to the ratings agencies taking potential action alerting the rest of the market to the situation.
By maintaining our detailed independent ratings we are able to better evaluate the published ratings and, we believe, more accurately assign value to the bonds we manage. This insight provides a significant advantage in our quest to locate bonds that are cheap at times when the market may be overly pessimistic regarding an issuers’ prospects. Ultimately, we feel that this credit knowledge has proven to be valuable during the uncharacteristic volatility we have seen over the past few years and has given us the confidence to make long-term commitments to credits that we might otherwise be inclined to sell.
Vice President, Municipal Bond Analyst
Kirkpatrick Pettis Capital Management
Kirkpatrick Pettis Capital Management is the sub-advisor to the Aquila Tax-Free Fund of Colorado and the Aquila Tax-Free Trust of Oregon, two of the Aquila Group of Funds. Before investing in any of the Aquila Group of Funds, carefully read about and consider the investment objectives, risks, charges, expenses and other information found in the prospectus. The prospectus is available from your financial professional, and when you call 800-437-1020, or visit www.aquilafunds.com.