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Credit Quality Demystified

The effects of Morningstar's new methodology for funds.

On Sept. 1, Morningstar changed the way that it calculates the Average Credit Quality statistic for fixed-income funds. This adjustment raised more than a few eyebrows, not all of which were lowered by the official methodology document.

So, let's try this again, in something that more closely resembles normal English.

In late 2009, Geng Deng, Craig McCann, and Edward O'Neal circulated a paper entitled "What Does a Mutual Fund's Average Credit Quality Tell Investors?" The paper argued that the standard approach for calculating the average credit rating for the bonds held in a fixed-income portfolio--the approach used just about everywhere, from Morningstar to the fund companies themselves to other data sources--would at times produce less-than-sensible results.

The standard method treats averaging credit ratings like averaging letter grades from school. In school, a student who receives two grades of A and two of C will post a grade-point average of 3.0, while a second student who receives a grade of B in all four classes will also record the identical GPA. Thus, in averaging credit ratings, the standard approach scores a fund that consists 50% of AAA bonds and 50% of A securities the same as a fund that consists solely of AA bonds. Similarly, a portfolio that is 50% in AAA and 50% in BB would equal to a portfolio of 100% A bonds.

We'll call the standard approach the GPA method.

Only ... there is a critical difference between grades and credit ratings. The scoring system that underlies a student's grades tends to follow a linear pattern. Mostly commonly, 90% is required for an A, 80% for a B, 70% for a C, 60% for a D, and less than 60% is a failing score.

In contrast, the underlying scores for credit ratings are very much not linear. Specifically, the cumulative default rates for bonds carrying investment-grade ratings tend to be relatively similar (particularly at the AAA and AA levels). Then, as the credit ratings hit BB and lower, the default rates increase at a massive and exponential rate, such that a lower-rated bond will have 100 times or more the default expectation of a highly rated security. To exit normal English, credit ratings are a convex function rather than linear. To return to normal English, lower-quality securities are very potent: A small dose of them can have a large effect in pulling down a fund's Average Credit Quality.

Consider one of the previously mentioned examples--the portfolio that is 50% in AAA and 50% in BB bonds. Per the data set used by Morningstar (the data will vary depending on the source and time period studied, but the pattern remains consistent), the cumulative default rate for AAA securities is 0.10%. For BB, it is 11.85%. Let's bring out the back of the envelope. The default rate for the AAA securities is roughly zero and for BB is roughly 12%, thus the overall portfolio must have an expected default rate of about 6%. What about a portfolio that is made up solely of A bonds? Recall that such a portfolio would be scored equivalently under the GPA method. The default rate for A bonds is ... 0.99%.

Oops.

Now let's consider a real-world example,  Loomis Sayles Bond (LSBRX). Several people have wondered how the fund could receive a BB Average Credit Quality score and land in the low-quality row of the Morningstar Fixed Income Style Box, because it has two thirds of its assets in investment-grade securities. To those accustomed to thinking along GPA lines, that result does not make sense.

Things become a lot clearer when accompanied by the underlying cumulative default rates.

(A note on methodology. Morningstar surveys fund companies for their credit breakdowns; that is, what percentage of the fixed-income portfolio is in AAA issues, AA issues, and so forth. This underlying data on default rates comes from the credit ratings agencies. Morningstar then processes these inputs by calculating an average score per fund--the Average Credit Quality statistic.)

Loomis Sayles Bond

Credit RatingPortfolio %Default Rate %Weighted Default Rate %AAA24.50.100.02AA4.80.230.01A12.10.990.12BBB25.12.360.59BB11.411.851.35B14.027.093.91Below B4.550.282.27Nonrated3.827.09*1.03Total  9.30*Nonrated corporate bonds are treated as B rated securities for the Average Credit Quality calculation. Nonrated muni bonds are treated as BB securities.

 

Note that the fund's 66% stake in investment-grade securities is essentially immaterial for the final results. That position contributes little default risk. However, the combined 18% position in B and below B bonds alone gives the portfolio an expected cumulative default rate exceeding 6%. With the addition of the BB bonds, the nonrated securities, and the small contribution of the investment-grade bonds, the portfolio ends up with an overall cumulative default rate that is only modestly better than that of a BB issue.

Implementing the new, cumulative-default methodology caused Morningstar's published Average Credit Quality scores to drop for many funds. Among taxable-bond funds (the effect was less with muni funds), slightly more than half saw their Average Credit Quality score decline by one or more ratings levels. In most cases, the decline was by a single ratings level, but about 15% of funds dropped two ratings levels. Funds that hold credits of a similar quality were relatively unaffected, while those that "barbelled" their portfolios by owning a mix of high and low credits were most affected.

Most big funds slipped by a single ratings level and shouldn't warrant too much investigation. For example,  Vanguard Total Bond Market Index (VBMFX) previously straddled the AAA/AA line; now it falls squarely into the AA bucket.  PIMCO Total Return (PTTAX) went from AA to A.

However, those funds that barbell and which therefore dropped two ratings levels, such as Loomis Sayles Bond or the new  DoubleLine Total Return Bond (DLTNX), may require a bit more thought. There's nothing wrong with being in a portfolio that assumes some credit risk, particularly with excellent funds such as the Loomis Sayles and DoubleLine examples that are run by former Morningstar Fixed-Income Managers of the Year, but that's a bet that investors will wish to be conscious of making. The new approach to the Average Credit Quality calculation is intended to better highlight when those bets are occurring.

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