Does the S&P Downgrade Affect the Morningstar Style Box?

Question: Does Standard & Poor's recent downgrade of U.S. debt have an impact on the Morningstar Style Box for bonds? Is Morningstar using its own ratings for the bonds in a portfolio, or does it get them from the ratings agencies?

Answer: On Aug. 5, 2011, following a fitful controversy in Congress over raising the statutory debt ceiling, S&P lowered its long-term sovereign credit rating on the United States to AA+ from AAA. According to S&P, the highest AAA rating indicates an "extremely strong capacity to meet financial commitments," whereas the AA rating indicates a "very strong capacity to meet financial commitments."

The downgrade probably didn't help soothe the nerves of an already-unsteady Wall Street last week, but it shouldn't have an impact on your funds' placement in our style box. That's because U.S. debt remains at a AAA rating, according to Morningstar's credit-quality rating methodology.

Bond Style Box Basics
Although Morningstar has begun assigning credit ratings to corporations, we currently rely on external ratings agencies to help us determine the credit-quality breakdown and style box for bond funds.

Specifically, we obtain credit-quality information for bond funds directly from fund companies, which provide this information in accordance with Morningstar guidelines. For each fund that has fixed-income holdings, companies provide that fund's percentage of fixed-income assets that falls into one of eight credit rating categories: AAA, AA, A, BBB, BB, B, Below B, and Not Rated. (Note that nonrated corporate bonds are treated as B rated securities for the Average Credit Quality calculation.)

To arrive at these credit-quality breakdowns, fund companies use ratings provided by one or more of the 10 Nationally Recognized Statistical Rating Organizations. These include big names such as S&P, Fitch Ratings, and Moody's, as well as lesser-known ratings agencies such as Egan-Jones Rating Company.

When providing their credit-quality breakdowns to Morningstar, fund companies must adhere to Morningstar's methodology for credit-quality classification, which is modeled after the Barclays Capital Global Family of Indexes ratings rules. That means that if credit ratings from three of the major ratings agencies are available--Moody's, S&P, and Fitch--the middle rating is used. Note that if ratings were available from only two agencies, the lower one would be used; if only one agency rating were available, then that sole rating can be used. Bonds not rated by an NRSRO fall into the Not Rated category.

In the case of U.S. debt, S&P lowered the U.S. debt rating to AA+, while Fitch and Moody's both maintained their AAA ratings. That means the middle rating was AAA, so S&P's downgrade didn't affect U.S. debt ratings in Morningstar's system.

Finding the Weighted Average
In addition to gathering the credit-quality breakdown information that appears on the Portfolio pages for bond funds, Morningstar also calculates a weighted average of the fund's credit breakdown. That calculation takes into account the fact that default rates for corporate bonds accelerate as credit-quality deteriorates, so funds with a big share of their portfolios in lower-quality bonds are penalized accordingly. For a real-life example, take  DoubleLine Total Return Bond (DBLTX). Its latest portfolio (as of June 30, 2011) had a meaningful 61% stake in the highest-rated AAA bonds, which implies minimal default risk. However, its combined stake of about 10% in AA down to B rated bonds, along with its 29% position in Below B and nonrated bonds, whittled down the portfolio's Average Credit Quality rating to BB. (This document describes our methodology for calculating average credit quality for fund portfolios.)

For the purpose of Morningstar's style box, those funds with an asset-weighted average credit quality of less than BBB are considered to have low credit quality. Those with asset-weighted average credit ratings of less than AA but greater than or equal to BBB are classified as medium quality, while those with asset-weighted average credit qualities of AA or above rate as high quality. Thus, with an average credit-quality rating of BB, DoubleLine Total Return Bond would fall into the low-credit-quality column of the style box. Treasury bond-heavy funds like  Vanguard Total Bond Market Index (VBMFX), with three fourths of its portfolio in bonds rated AAA, land in the high-quality section of the style box.

Together with a fund's interest-rate sensitivity, average credit quality helps determine a fund's placement in the fixed-income style box--a nine-square visual snapshot that depicts a bond fund's portfolio characteristics.