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How Bond Managers Hide Their Funds' True Risk

Managers of bond mutual funds typically report an "average credit quality" statistic in their marketing materials, based on individual bond ratings from Standard & Poor's and Moody's. Until recently, mutual fund research provider Morningstar also calculated and reported average credit quality statistics.

Unfortunately, just as you can drown in a stream with an average depth of six inches, average credit scores can be misleading because they can overstate a mutual fund's true credit quality. Making the problem worse is that given knowledge of how this statistic is calculated, portfolio managers can easily manipulate their holdings to significantly increase their credit risk (thereby increasing their yield) without increasing their reported credit risk.

This is dangerous because bond fund managers compete for your assets based on yield and risk. Thus, fund managers have a strong incentive to "game the system," misleading you into taking more credit risk than you either are aware of or might find acceptable.

How Fund Managers Can Pull This Off For the average credit quality statistic to be useful, it must reflect the average credit risk of the individual securities held in the portfolios of mutual funds -- two funds with the same rating should have the same credit risk. Unfortunately, this is far from the truth. The reason is that while credit risk increases at an increasing rate as you move down the rating scale, the calculations of average credit quality assume that credit risk increases at a constant rate as we move down. In other words, the calculations assume a drop from AAA to AA is the same as from A to BBB, which certainly isn't the case.

Mutual fund companies simply assign a score to a corresponding rating, then tally up the total and divide by the number of holdings. That average is matched with the closest rating score. Let's use ratings from Moody's as an example. A fund could score the ratings as such:

This means a fund could have 125 holdings rated Aaa and 75 holdings rated C and be rated Baa (or investment grade).

The problem could be even more extreme. Most funds have a cutoff point where all funds rated at or below a certain level are given the same rating. For instance, a fund could make BB its cutoff and give all funds at or below that rating the same score, even though CCC/C (the lowest grade) bonds have more than five times the credit risk. In addition, some funds exclude unrated bonds from the calculation of average credit quality.

Tomorrow, we'll see a live example of this: Is Your Bond Fund's Rating a Lie?
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