The growing use of municipal derivatives heightens the importance of rating agencies, according to Mary Schapiro, acting chairwoman of the Securities and Exchange Commission.
Derivatives complicate the credit analysis process, especially for retail investors, Schapiro said at a conference in New York City sponsored by Standard & Poor's Corp.
Credit analysts reviewing a derivative product linked to an interest rate swap must analyze the swap counterparty's credit standing and the terms of linkage between the swap and the securities, Schapiro said at the July 22 conference.
The SEC officials also warned investors that traditional ratings may not encompass all of the risks inherent in derivatives, such as market risk.
Derivatives yields and prices are frequently more sensitive to changes in interest rates, making them more volatile than ordinary bonds. Such increased volatility means the derivatives are subject to more market risk than similarly rated ordinary bonds.
"Because these instruments often entail significant market risk, it is important that retail investors understand that an investment grade rating speaks only to the ability of the issuer to make required payments and not to the market rate volatility of the instruments," Schapiro said.