Is Your Bond Fund's Rating a Lie?

Yesterday, we saw how bond fund managers could theoretically inflate their fund's average credit rating. Thanks to a recent study, we can see this in action.

In their study, "What Does a Mutual Fund's Average Credit Quality Tell Investors?" Geng Deng, Craig McCann and Edward O'Neal, examined the case of the Putnam Income Fund (PINCX), a taxable intermediate-term bond fund with $1.1 billion in net assets as of September 2009. Putnam claimed an average credit quality of AA for the fund, and Morningstar also gave the fund an AA rating. According to Standard & Poor's, the cumulative five-year default rate of AA-rated securities is 0.28 percent.

However, if we assign S&P's cumulative five-year default rates to the bonds in the Putnam fund and weight them by the amount invested by Putnam in each rating category, the weighted average five-year default rate for PINCX is 3.26 percent. This level of credit risk corresponds to securities rated between BBB and BB, more than two whole rating categories below the average credit quality reported by Putnam and assigned by Morningstar.

Thus, investors who relied on either Putnam's or Morningstar's rating of AA were unaware that the credit risk of PINCX was 12 times as great as a portfolio of AA-rated bonds. It's important to note that the authors found that PINCX wasn't unique. They found that the linear scale used by Morningstar and the mutual fund companies significantly understates the credit risk in bond fund portfolios because it assumes that lower-rated bonds are safer than they actually are relative to higher-rated bonds. According to Moody's for example, a Ba-rated bond was 89.3 times more likely to default over a five-year period than an Aaa-rated bond. However, a linear scale assumes that a Ba-rated bond is only three times as risky as an Aaa-rated bond.

The authors provided the following example to illustrate how "diversification" across credit quality increases credit risk, and how the average credit quality statistic allows mutual funds to hide this increased credit risk from investors.

• Fund X holds only BBB-rated bonds.
• Fund Y's portfolio is 50 percent A+/50 percent BB-.
• Fund Z's portfolio is 50 percent AAA/50 percent CCC rated bonds.

The problem is so pervasive that the authors found that:

• Just 6 percent of bond funds warranted the credit quality assigned by Morningstar. As noted, Morningstar recognized the flaw in its system and changed its methodology to more accurately reflect credit risk.
• Fifty-four percent had default probabilities that would place them a full letter grade below that assigned by Morningstar.
• Thirty-nine percent had default probabilities two full letter grades below that assigned by Morningstar.

• Mutual funds can have dramatically different credit risk amounts despite having the same reported average credit quality.
• Funds with more dispersed holdings will have higher yields (and more risk) than funds of the same reported average credit quality that have more focused holdings.
• Small reductions in reported average credit quality can mask dramatic increases in credit risk.

More on MoneyWatch:
How Bond Fund Managers Hide Their Funds' True Risk How to Build a Bond Portfolio Book Review: The Power of Passive Investing Is Inflation Risk Overstated? Has a Way to Find the Best Performing Managers Been Found?
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