Q: Currently, Standard & Poor's provides a credit rating service for bond funds. Why expand to market risk ratings?

O'Neill: Obviously what we've seen, and many others have seen, is that the larger risk that's emerging in bond funds today is not credit risk, per se, but market risk. We are concerned that our relatively high credit ratings -- AA, AAA, primarily AAA -- may be construed to mean that all risks are relatively minimal, when all risks are not.

So we've developed a methodology to better measure market risk than what anybody else is doing and then classifying that market risk across the range of the different types of bond loans.

Q: How will it work?

Bragg: What we've done is put in place three different Types of analysis. We use historical analysis as our basis. We also are combining that with portfolio analysis. And then we do a management evaluation, including ongoing surveillance, on a monthly basis.

Q: Some people cite the past performance and volatility of a fund as a measure of its riskiness. Why isn't that enough?

Bragg: The problem with historical information is that 50% of all bond funds that are out there now have been created in the last five years. So you have limited historical information, number one. And number two, they've been operating in an interest rate environment which has been low and falling -- essentially very kind.

For those reasons, I think you have to be careful with historical information. We use it. We do look at the historical risk profile, the volatility of returns. But we felt very strongly that you need to go further than that.

Q: Can you run through a basic hypothetical example. How would you determine the rating for o particular fund?

Bragg: Let's take a government fund. If you look at a standard government fund, you have a variety of different aspects contributing to risk. One, what is the direction of the fund? Where on the yield curve does this fund sit? Are they going to be on the intermediate sector, the long-term sector, or what have you?

Now, a government fund may also have the latitude to invest in other types of securities agency securities or certain types of derivative securities which are permissible under its investment guidelines. And those may or may not be contributing to the risk profile. So you need to look at the asset composition. [Is it] 100% Treasuries, or is it some combination of various government and agency types of securities?

You need to look at those factors that contribute risk other than just interest rate risk. What sectors of the government market is it in, and what types of structures, and what kind of strategies are they applying? Then what you come up with is an overall risk assessment -- where does it fit, where do all those line up?

Q: There's another element in the municipal area -- the relationship of the tax-exempt curve to the taxable curve. Is that also an element?

Bragg: When you start getting into sectors like the municipal area, you have other risks that you need to consider, such as liquidity. You need to look at what are the sectors that a fund has invested in. Clearly, if they're investing in the housing sector or the health-care sector, that has different implications than if they are in the GO sector.

Q: How are you addressing derivatives? Are there special questions that surround derivatives?

Bragg: There are always special questions around derivatives. Clearly derivatives are an area of concern for investors, for fund companies, for regulators. It's a very complex area.

We feel it's important to put the use of derivatives in context. The use of derivatives can be beneficial. It can be used for hedging purposes to provide more liquidity to a fund as a substitute where there's a lack of supply.

But what are the overall strategies? Are they being used for speculative purposes for more yield, or are they being used to essentially manage and control the risks within a fund? Similarly, you need to look at what controls and what tools the funds are using to manage it. Clearly the more enlightened and the more informed they are, the better it will be for them to manage their derivative exposures.

Q: What about mortgage derivatives? That's been a pretty nasty area recently. Some funds, and even sophisticated dealers, had models that said if you invest in this, this is your upside, this is your downside. But it turned out the models were wrong. They lost tens of millions.

Bragg: All models have underestimated the level of prepayments experienced. No model which is derived from historical prepayment schemes has adequately captured the experience over the last year. We look at the available models. We put them in the context of everything else. We factor in something we call model error. We don't trust the models, so we add in additional factors. We also put it in the context. We're looking at not only the models, per se --they're just one tool. We're also looking at the quality of the management, and we're also looking at historical experience. So we're not creating a black box that we are blindly following.

Q: So once the ratings are available, is that all an investor needs to know? Could someone make a purchase looking only at this new Standard & Poor's rating?

Bragg: I, as an investor, would then combine that with other available information. Investors will continue to use the same sources they already use in terms of getting performance information and making final decisions of what is the appropriate fund. We're just addressing one dimension, but there are many other dimensions that investors will want to look at before they finally make a decision to invest: performance, expenses, and their own investment objectives as to how that fits into their overall portfolio and asset allocation strategies.

Q: Once you put out these ratings, how does an investor find out about them?

O'Neill: First, we'll have the list of ratings that would be generally available to broker-dealers and individuals. Second, we will be preparing reports on all these funds, which not only delineate the credit risk, as we've seen, but also the market risk.

There is a distribution problem in this. How do you get out to several million individual investors? How do you do that? It's really a difficult issue. We hope to advertise to the market that we have these ratings available. We'll have a hot line that people can call and ask.

Q: That anyone off the street can just call?

O'Neill: That's right. In some respects, I hope it's not too successful! It would be an 800 number. We will have informational brochures of booklets that we will be mailing out to people. We will work with the fund sponsors on their funds to generate the informational pieces. Our editorial input, and their distribution. And there will be articles for magazines.

I had an interesting idea. Yesterday, I was walking to the SEC, and I passed by the AARP building, the American Association of Retired Persons building. To me, they would be a perfect outlet for us -- to do articles for their magazines and sending them lists, stuffers. I think they would like that.

Q: What if The Bond Buyer wanted to write a story about bond funds -- could we print a list?

O'Neill: Absolutely, yes. It's in our best interest to get maximum market exposure from these ratings, so we'll use any and all entities.

Sandy [Bragg] and I talked about a newsletter. I don't know. We'd have to do some more market research.

Conceptually, it's very similar to the way we distribute bond ratings. We make the ratings freely available through the media and through every other available source. We're not trying to put a price tag on obtaining this information.

Q: You mentioned cooperating with the fund managers. What's their role?

Bragg: Because of the expansive nature of the analysis that we do, we require the cooperation of the fund sponsors. Much of the information is not, at this point, publicly available. We need the cooperation not only for the portfolio analysis, but also for the management assessment, and then obviously, for the ongoing surveillance on a monthly basis.

Q: If you launch the product in mid-January, would the new ratings be available for every fund immediately?

Bragg: When we launch, we will provide all the details in terms of the actual rating system. We will also have at that time a number of funds which are rated. We will also have benchmarks for each ratings category, what has been the historical risk profile and historical return profile for each trading category. How does a standard Ginnie Mae fund compare to your standard ARM fund, compared to your standard single state municipal or your general municipal fund.

Given the state of disclosure today, until we get to a point when we get good and timely portfolio information [publicly], we're going to have to, unfortunately, rely on the cooperation of the funds. So to the extent that we are able to provide information for which there is a strong need, and there is use, then hopefully that will have induced more and more people to agree to participate in his process.

Q: Can you throw, a number out? In January, will there will be 10 ratings or ratings for 10% of all bond funds.?

Bragg: Right now we rate about 5% of the bond funds on a credit risk basis, and I would say that's the order of magnitude that we would expect, either at launch or shortly after launch.

Q: What is the incentive for the funds to participate? What do they gain

Bragg: Up until now, marketing has all been based on performance. And they don't like that. It puts tremendous pressure on them to get extra basis points in yield, and potentially look at risks that they wouldn't normally like to look at. It's very difficult to run a conservative fund in a low-yield environment where performance is the name of the game.

But the reality is, that is the way funds are being evaluated for the most part. It's going to take time to change.

We think that it's in everyone's interest to begin that change now rather than waiting until interest rates move. Unfortunately, if you look at the historical patterns of ratings acceptance, you see that commercial paper ratings really had a boost in the early 70s after the Penn Central performance. After you had a disaster, then everyone was suddenly interested in ratings. We're hoping that we can be proactive in this situation and contribute to better dissemination of risk information so that there is no equivalent disaster.

Q: So you want people to look at market risk ratings before there is a market risk problem?

Bragg: There has been a tremendous inflow of investors who have moved from [certificates of deposit] to mutual funds, and those investors have tended to be very risk-averse. I think there's considerable worry throughout the industry, the [Investment Company Institute] itself is concerned about it, to make sure that those investors are educated in terms of all the risks. They don't want them to be surprised one morning and open the paper and see that, lo and behold, what they thought was a safe investment can lose money.

O'Neill: The interest rate environment over the last 10 or 15 years has been a very favorable market for bond investment. We think that the next major cycle in bonds will be less favorable, and as a result, there will be, perhaps, some turmoil within bonds, and, more importantly, within bond funds -- which is fine. I mean, no one is happy about that, but that's a fact of life.

But if there is no disclosure as to those risks, then the impact will be extended or expanded. Just the loss of principal itself, the loss of any net asset value growth, is one thing, but if people say: "Gosh, I had no idea that that risk was embodied in the fund. If I had known, I wouldn't have bought it."

For almost 10 years, interest rates have gone down and individual investors have moved money from low-yielding bank accounts into higher-yielding fixed-income funds.

The quest for higher yields has brought more risks. Investors cannot lose principal in a certificate of deposit, but they can in mutual funds if interest rates increase.

If mutual fund investors are shocked by losses of principal, they may yank their savings in a hurry. The resulting wave of redemptions could put further pressure on the markets.

Officials at Standard & Poor's Corp. saw an opportunity for a new, product that would warn investors about the market risk inherent in fixed-income mutual funds.

Leo O'Neill, president of the ratings group at Standard & Poor's, and Sanford B. bragg, managing director of ratings development, sat down with staff reporter Aaron Pressman to discuss their new "market risk" ratings.

To create models for measuring market risk, the rating agency analyzed historical data for more than 1,400 fixed-income mutual funds dating back 15 Bragg said. "We subjected the data to 4,000 regressions," he said.

But to rate a fund, the analysts need the cooperation of the fund's managers. Persuading funds to come on board could be O'Neill's and Bragg's toughest hurdle.

After Standard & Poors rates a fund, analysts will monitor the fund on a monthly basis. Monitoring will also require the cooperation of the funds.

The new ratings will probably unveiled in January, Bragg said. The rating scale for funds will be similar to the agency's credit rating scale, but it will be denoted in lowercase letters.

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