A Better Look Under the Hood of Your Bond Fund

Jason Stipp: I am Jason Stipp from Morningstar. Morningstar recently made some changes to how we calculate the average credit quality score on your bond mutual funds.

Here with me to talk about why the change was made and what the new score can tell you is John Rekenthaler. He's Morningstar's vice president of research.

John, thanks for joining me.

John Rekenthaler: Sure. Thanks, Jason.

Stipp: First question for you, average credit quality score, what is this data point? What does this data tell you about a bond fund?

Rekenthaler: The average credit quality score, we look at all the bonds that a fund owns, if it's a fixed income fund or a balanced fund, and each bond will typically have a credit rating -- one or more credit rating agencies will say this is AAA or AAA if it's Moody's, so it's BBB and so forth.

So we look at all those ratings and we try to roll that up and come up with an average score at a portfolio level, so that we can describe a fund and say, in aggregate this is a BBB quality fund or a A quality fund. It doesn't mean every security has that rating – generally speaking, every security is not that, but that's where it ends up at or that's what it would tend to behave as, that's the intent of the credit quality score.

Stipp: We have a new way of calculating that for now. But before we get to that, how was this calculated previously and what things went into that score as it used to be calculated?

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Rekenthaler: As it used to be, the term forward is basically an equal weighted or a linear measurement. I don't want to get too technical here especially since we don't have any diagram to right on. But just the idea was, if you had a portfolio, it's a management portfolio, that was half than AAA securities and half in A securities, so in between is AA. So we'd say, okay, and this is intuitively what you'd think. If you're half in AAA and you're half in A, then your portfolio will show up as a AA average, that's the normal way, equal weighted average. So that was how not only Morningstar but the fund industry overall historically has done things.

The problem with this approach is that default rates on bonds don't follow a line like that. What happens is, as you move down in credit quality, they move up exponentially and default rates become exponentially higher. So if you go from AAA to A, maybe the default rate is five times higher for A than for AAA and you've gone down two notches. You move two notches more from A to BB, it's not 10 times higher. That default rate is, I think it's 40 times higher in BB than it is A.

So your function is not flat like that. You get increasing risk as you go down the credit ladder, and the traditional industry method of averaging calculation did not capture that correctly.

What happened is, you'd have a portfolio that would be say half of AAA securities and half of very low rated securities, and we'd show it as maybe a BBB – A, BBB-type portfolio, but actually it wouldn't behave like that. It will behave more like a BB portfolio, because it had a lot of these securities. This barbell approach is putting a lot of securities with a much higher default rate.

Stipp: So as you guys in the research department were sharpening your pencils and looking at this discrepancy, what did you do in formulating the new methodology that can capture this effect that you see?

Rekenthaler: Well, the new methodology -- and that's pretty simple. We just go by the historic default rates. So if the historic default rate for a B security is a 100 times higher than a AAA security, basically that security will get a score of a 100, as opposed to one for the AAA security and two for the AA and so forth.

So you get just a relatively small number of bonds with those very low credit scores and that will pull down the overall portfolio, which reflects -- it's maybe only a small portion of the portfolio, but there's quite high risk of default with that small portion of the portfolio. So it ends up, if you look at it, as kind of a curve, so the term is that we've gone from a linear scale to a curve scale.

Stipp: Okay, and you mentioned how in one sample if there's a small portion that was lower quality, what effects might that be. So as you roll these ratings out to the bond fund universe, broadly what kind of trends that you see and how the ratings change from the old methodology to the new methodology?

Rekenthaler: Well, certainly it doesn't affect anything like the government fund that was AAA, all AAA to start with, so it doesn't touch those. Most of the funds that are not -- if they are not a AAA government fund and there are a very large proportion of funds that are AAA or they are insured as the case may be, they're untouched.

The rest of the universe typically would move down; nobody goes up, right. So the average credit score would move down maybe a notch, say, from AA to A that would be PIMCO Total Return, the largest bond fund out there. So they were AA, they are now A, they were investment grade, they are still investment grade.

Not a huge change, but a modest change. So most funds move down a notch. There were a few that made more dramatic moves. The more a fund is barbelled and had a strategy that was – they didn't have much in the middle, but they had a lot of bonds on one end of the credit spectrum and a lot on the other end, those are the funds that would move down.

Stipp: Okay. So as an investor, so the changes that I had seen recently in my fund, if I got an alert on my fund because of this change, it's because of the way that we're looking at the portfolio now, not necessarily because we saw changes in the portfolio, so if I did see, then, that I had a drop in my rating, what should I think as an investor, what does this mean to me as far as, should I sell this fund, should I think differently about this fund, practically speaking what should I do?

Rekenthaler: Well, one, if you got a rating this week, an alert on your average credit quality change, it's almost certainly not your fund changing, it's our methodology, because this was the week that we made the change. Second, if it's only down a notch, I wouldn't worry about it at all. That means basically most funds move down a notch, it's just one credit rating, and there's probably nothing remarkable going on with your fund.

If it moved down more than one notch, I'd look closely in making sure you understand the strategy of the fund, because that is indicating probably some sort of barbell, that may be okay with you, but it could be that you thought you had an investment grade fund, you wanted an investment grade fund, and at 70% in investment grade securities and 30% in something that's pretty low, under the old system that might still show up at the bottom of an investment grade or at least it would be a higher credit score than under the new system.

So the new system really -- the change to that really is functioning as an alert. Our whole job in research is to, say, make sure you know what you have and know why you own that. So I would look at that if you got a signal that says your fund moved down more than one notch in credit quality, two or more, that truly is alert to me; make sure that you know what you own.

Stipp: Certainly worth some further investigation on that. Thanks for joining me and for the explanations.

Rekenthaler: As always Jason, thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.