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Average Credit Quality

Average credit quality gives a snapshot of the portfolio's overall credit quality. It is an average of each bond's credit rating, adjusted for its relative weighting in the portfolio.

Historically, Morningstar has reported the simple average credit rating of a bond portfolio—an industry-wide practice that assumes the default rate curve is linear. However, because default rates for corporate bonds accelerate at an increasing rate as credit quality deteriorates (a mathematical property called convexity); the old methodology systematically understated the average default rate of a bond portfolio.

On August 31, 2010, Morningstar introduced a new average credit rating calculation that accounts for the inherent convexity of the default rate curve to correct this bias. When classifying a bond portfolio, Morningstar first maps the Nationally Recognized Statistical Rating Organization credit ratings of the underlying holdings, which are provided to Morningstar by the fund companies, to their respective relative default rates. We then average these relative default rates (rather than the grades) to determine the average relative default rate for the entire portfolio. Finally, we map this average relative default rate to its corresponding credit rating along the aforementioned convex curve.

U.S. government bonds carry the highest credit rating, while bonds issued by speculative or bankrupt companies usually carry the lowest credit ratings. Anything at or below BB is considered a high-yield or "junk" bond.

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