[trailrunner46]

As someone who has spent a lot of time in the Fixed Income world of finance I think it's great to see a paper where the researchers spend time and energy looking at the methodology a major player in the space such as morningstar is using. The easiest way to improve your returns in corporate credit is to buy lower rated (riskier) bonds as they are more equity (stock) like since you have a larger component of default risk baked into the security price. Over the long term the lower rated bonds will return more but will do so at higher risk. If you can convince morningstar which puts managers into discreet buckets to put your fund in a bucket that is safer than your actual bonds reflect, you now appear to have more return than your peers (although in reality its just because you have more risk).

The lack of accurate risk (reflected by the average bond ratings of your holdings) is what is really at the core of this argument. The researchers joined together some pretty commonly used datasets in the industry (probably what I would use if I were to do this) and impressively were able to properly take the holdings of managers and come up with a proper risk picture (if you believe that rating agency ratings of bonds reflects the true risk but that for another post). Morningstar basically said that they have a crappy dataset which just doesn't have rating data for many bonds and therefor, when they don't have a value, they just fill in with a default. This makes me think that Morningstar is doing a pretty lazy job in their evaluation of managers (what incentive do they really have, they are a monopoly in this area).

Happy to answer any questions people have.

[pascalxus]

Thanks for the explanation.

Do you see the same kind of risk problems in the muni bond space? For instance: PZA, MLN, FCAVX all show that they're 100% investment grade. Are these among the funds that are actually more risky than they appear?

What's your opinion on CEF Muni bond funds like: MYD, IIM, VGM, NVG, NAD, MHI. I know they're relatively risky but should do fine as long as the world isn't completely falling apart. I've seen some professionals say the credit markets are kind of binary. When things are good, they're always going up. And when things get really bad, everyone wants to sell at once. is this true of muni bonds as well?

[trailrunner46]

The closed end funds can be tricky if yields start to rise as the leverage they use gets more expensive. Frankly I am not much of a muni expert so hard for me to speak about munis specifically. In general though bond investors are worried about the binary default scenario, they are either getting paid over time or all the sudden not. However its important to keep in mind what kind of bond is being considered... an IG highly rated company has a large fixed income/duration component and then is at the mercy of the market pricing of the spread from government to corporate (widens when things look riskier, which means the bond price will fall). High Yield companies have less duration to worry about as a % of the return, its much more about the risk of the company (get paid for a while while the company is operating fine, but can get wiped out in a downturn).

[smallnamespace]

How do managers construct bond portfolios nowadays? Are they just picking some parameters (e.g. domestic, muni, etc.) or a benchmark and then letting software do the actual security selection?

[trailrunner46]

Most of the AUM are in portfolios that are benchmarked to something (Barclays/Bloomberg US Aggregate for example). Although recently there has been a surge in unconstrained bond funds which have more latitude in terms of what they hold and with a looser benchmark. Managers start with a benchmark and then make 2 main choices. 1) how much should I deviate in terms of asset type exposure (benchmark is 40% IG corporate, should I do 50% and overweight?) and 2) within each asset type exposure which securities should I select (within my IG corporate sleeve should I choose the newly issues IBM bonds, old issue IBM bonds, Apple?, etc). Most managers are still pretty manual so the are doing deep securit research and are picking company A over company B but there is some movement to a more quant approach where you pick metrics and do a broad screen across all of those companies. The data across all of the bonds especially outside of just investment grade is hard to get access/clean so that has been a barrier to entry for a while. As the data becomes more available more managers will be using screens like has been commonly been done in equities.

[ethbro]

What legal agreements actually exist between ratings agencies and their consumers?

As I understand it, there are legal agreements that take ratings as an input (e.g. a pension may only invest in investment grade bonds).

But is there actually any way for a consumer to sue Morningstar? Or are their ratings essentially just "proprietary numbers", no warranty given?

[lotsofpulp]

Based on the consequences to the ratings agencies of fraudulently (or erroneously) rating mortgage debt in 2000s, there are no laws requiring ratings agencies to be accountable to anyone.

The sellers of the debt, or financial products, are the ones that pay the ratings agencies, so they are the real customers.

The buyers should be doing due diligence, especially considering the conflict of interest, but they are also frequently agents on behalf of taxpayers (for government pensions) or other far removed investor, so agency risk is big here too.

[trailrunner46]

Morningstar is just putting information out there, they have all sorts of language saying they are not giving you investment advice so there isnt much recourse there as far as I am aware (but I am far from a lawyer). The pensions may only invest in X are hard guidelines so certainly a manager would be in trouble if they violated that but that would be rare, much more likely a manager would just be holding more borderline IG paper and trying to look like they have better IG paper in aggregate.