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Is Your Bond Fund Really Safe?

Investors’ once-safe bond funds may not be so safe anymore. That’s because the research firms responsible for assessing the safety of bonds have changed their methodology as of Sept. 1. For many investors, the move means that the investment-grade bond fund they thought they were investing in could now have a credit risk similar to a junk-bond fund.

Before the change, research firms like Morningstar determined the safety of bond funds on the credit ratings issued by rating agencies like Moody’s or Standard and Poor’s. The new methodology is based on default risk.

As reported Sept. 27 by the Wall Street Journal, more than half of the domestic taxable bond funds tracked by Morningstar saw their average credit-quality ratings fall under the new methodology. About 43% of bond funds fell by one credit grade and about 13% dropped by two credit grades, according to the Wall Street Journal article.

Several bond funds, including Federated Real Return Bond Fund, Cavanal Hill Intermediate Bond Fund, Neuberger Berman Short Duration Bond Fund and TCW Short Term Bond Fund, dropped by even more. In some instances, the funds fell to non-investment-grade ratings, such as BB, from investment-grade ratings of AA.

The new methodology comes on the heels of research from Securities Litigation & Consulting Group, a consulting firm that provides expert witnesses to regulators, law firms, banks and brokerages. The company’s study, published in November 2009, revealed that the mutual fund industry often reported average credit-quality ratings that were at least one whole letter credit-rating higher than the portfolios’ true credit risk.

According to Craig McCann, one of the study’s authors, Morningstar’s change is likely to “have a significant impact on bond portfolios that spread out their credit quality.”

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