What Does a Mutual Fund’s Average Credit Quality Tell Investors?

Abstract

Managers of bond mutual funds frequently report an “Average Credit Quality” statistic in their marketing materials. This statistic is based on Standard & Poor’s and Moody’s assessment of the credit risk of the individual bonds in the portfolio and is reported to mutual fund investors using the familiar letter scale for rating the credit risk of bonds. However, the Average Credit Quality statistic as typically calculated by the mutual fund companies and by Morningstar significantly overstates mutual funds’ true credit quality. Given how this statistic is calculated, portfolio managers can easily manipulate their holdings to significantly increase their credit risk and thereby their yield without increasing their reported credit risk. Since bond fund managers compete for investors based on yield and risk, fund managers who report Average Credit Quality have the ability and the incentive to increase but underreport the credit risk in their bond mutual fund portfolios. In this note, the authors explain the methodological flaw in the way Average Credit Quality statistics are calculated and provide simple examples of its systematic understatement in credit risk.