From time to time I am asked to take a look at an individual’s portfolio and express an opinion about what I see and make recommendations for their consideration. As a first step, I look to see how much of the portfolio is invested in mutual funds and especially bond mutual funds. Why do I do this?

Bond mutual funds present the investor an easy way to invest in a collection of carefully selected individual bonds so that the investor does not have to pour over mountains of bond reports and ratings. The fund should be either focused on a broad market segment such as corporate, or targeted at a specific area such as high yield. In the past, this was the only way to invest in a collection of bonds economically, without trying to select individual issues. Today, the alternative of exchange traded funds is offered and is personally preferred by me over mutual funds, but that is another story. Today we want to look at the ratings of the individual holdings within the fund.

Doug Tengdin mentioned in Global Market Update that, “in 2011, of the 53 bond defaults, 47 were issued as either with junk ratings or as unrated bonds”. If I am investing in junk or high yield bonds I completely understand the risks associated with the rating. It is clearly stated that under tough economic times the probability of default is high. However, the unrated bond is, well, unrated. No opinion is being expressed by the rating agency. Now, that is not a problem if you treat the bond as a high risk item and invest accordingly or do the rating work yourself. It is a tough job but, you can do that if you are buying them individually.

Unfortunately, more “unrated” bonds are creeping their way into mutual funds in an attempt to boost yield, the income component. This way a fund can show a great income level relative to the competition and the investor feels good, at least until the “unrated” bond defaults and the fund absorbs the loss.

I am writing about this today because when I show investors how unrated bonds are more than just a passing fancy in the overall allocation they have no idea how large of a percentage the unrated bonds are in the fund. Most are surprised as to the risk that is associated with this class of bonds. In my opinion, it is not the fault of the investor but, more in the lack of understandable information available to the investor at the time of purchase.

Every mutual fund might have a very small percentage of unrated bonds but, I have seen percentages as high as 50%. And, each time I point this out to an investor they have been surprised, so, somewhere along the line it was not explained to them, or it was not explained so that it could be understood.

An easy way to see the ratings of the bonds within a fund is to use one of the mutual fund analysis tools that provide how much of a fund is in each classification. Morningstar has an excellent tool available in the portfolio analysis section. This is just one that is available and there are several others. I am not endorsing or recommending any specific analysis tool as there are several good ones available.

Rating agencies use different symbols to mean the same thing such as AAA versus Aaa. Don’t let the alphabet soup scare you. It is similar to the traditional school grading system; the lower the grade, the higher the risk. The chart in this message shows the three major rating agencies and how to interpret their scores. It is available on Wikipedia.

One of the items I like to look at when evaluating a bond mutual fund is to see the percentage of the bonds in each classification. Using this quick view it is easy to see where the fund is placing emphasis. If the percentage is tilted to the higher ratings and there is a low percentage of unrated bonds, credit quality is important. If you find more of a tilt to the middle or lower rating classifications such as BBB or BB (Baa2,Ba2) and the percentage of unrated bonds is high, be careful. You will need to take a good look at the individual holdings to see if you are comfortable with the overall structure of the bond holdings.

You will see more of a tendency for mutual fund managers to tilt toward the lower grade ratings and unrated bonds in an attempt to gain yield (income) because of the very low interest rates in the high credit quality world.

Low interest rates are short to medium term and more evidence is suggesting that rates will be going up in the near future. Don’t be tempted to chase yield and take on higher risk than you feel comfortable in doing just to get better income numbers. If you are investing in bond mutual funds, get the facts about how the fund is structured in terms of quality. Look for how much of the portfolio is in each classification and be careful as to how much is “unrated” or “unclassified”. And I always recommend rule #1, if it is not understandable or comfortable …. DON’T DO IT.