Bond mutual funds often report an "average credit quality" in their marketing materials. A fund's average credit quality is represented by a rating (e.g. A, A-) that is based on the credit ratings of the fund's individual securities, and these credit ratings come directly from rating agencies such as Standard and Poor's and Moody's.
In this paper, we explain a methodological flaw in the way average credit quality is calculated and argue that a bond mutual fund's purported average credit quality easily overstates its true credit quality. Bond mutual funds compete for investors on the basis of yield and risk, the higher the yield or the lower the risk, the more competitive the fund. Therefore, not only do funds have the ability to manipulate their average credit quality, they also have the incentive to understate credit risk and overstate average credit quality.
