Bond funds face a harsher reality

Morningstar changed its rating formula, causing some funds to drop to junk status.

By Kim Peterson Sep 27, 2010 1:00PM
Woman leaning on files © PNC/JupiterimagesThink you invested in a solid bond fund? Might want to check again.

This month, Morningstar changed the way it rates bond funds to give lower-rated bonds more weight. As a result, a big chunk of funds saw their "average credit quality" rating drop, according to The Wall Street Journal.

Some funds saw significant drops from AA to junk grade. They include the TCW Short Term bond fund (TGSMX) and the Neuberger Berman Short Duration bond fund (NSBIX). AAA is the highest rating possible, while a BB and lower denotes junk status.

So now some investors are finding that their once-hot bond funds have a greater credit risk than they thought. Morningstar told the Journal that 43% of bond funds fell by one credit grade, while 13% dropped by two. That's a huge, huge change.

The "average credit quality" ratings are an assessment of the underlying securities in a fund. Those securities get their own ratings -- from Moody's or S&P, for example -- and Morningstar collects those ratings for an overall average credit quality grade.

The higher the rating, the lower the anticipated losses, the Journal reports. Post continues after video:
So why the change? Morningstar was a little too confident in the lower end of the credit spectrum. Morningstar assumed that default rates rose steadily, even in lower credit territory. But in reality, the Journal reports, default rates spike up in the low-credit bond ghetto.

In fact, one study last fall found that mutual funds generally put a positive spin on ratings and in many cases gave ratings that were one letter grade higher than the true credit risk, the Journal reports.

So Morningstar changed its formulas to put more of a red flag on lower-rated bonds. And that sent a bunch of funds into junk-bond status. In fact, the funds with that rating more than doubled to 13% of the total from 5%.

"If the credit rating moved down more than one notch, I'd look closely in making sure you understand the strategy of the fund," a Morningstar executive told the Journal. "If it only moved down a notch, I wouldn't worry about it at all."

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