What it means
A portfolio might hold hundreds of bonds or loans, each with a different credit rating. Looking at every one is impractical, so analysts need a way to summarise the overall quality.
The weighted average credit rating does this in one figure. The method has three steps.
Each rating is translated into a number on a scale, where better ratings have lower numbers, and each is multiplied by the amount held. The results are added and divided by the total amount, and the answer is converted back into the nearest rating.
Rating agencies use their own scales, and the gaps between ratings are not equal. A move from a high to a low rating on the scale usually represents a much bigger jump in the chance of default than a move between two high ratings.
For this reason professionals often use a scale that grows faster at the lower end, but a simple scale is enough to explain the idea. The measure is common in funds, collateralised loan obligations (pools of company loans packaged and sold to investors) and covenants.
Rules may require the weighted average rating to stay above a floor, and breaching the floor can trigger restrictions or require the manager to change the portfolio. Investors also compare it between funds to see which carries more credit risk.
There are limits to bear in mind. An average can hide a few very weak holdings, and a portfolio rated A on average may still contain several poor-quality loans.
It should be viewed with other measures, such as the share of low-rated assets and the concentration in any one borrower.
In practice
Real-world examples.
Example
A bond fund reports its weighted average credit rating each month to investors. When the figure moves from A to BBB, the manager explains that it has bought more lower-rated bonds to earn a higher yield. Investors can see that the fund has taken more credit risk.
Example
A manager of a pool of company loans must keep the weighted average rating above a set level under the terms of the deal. After several downgrades, the pool is close to the limit. The manager sells weaker loans and buys stronger ones to stay within the rule.
Example
A pension fund compares two bond funds. One shows a weighted average rating of AA, the other BBB. The trustees accept that the second fund may pay more income, but they note that it carries a higher chance of defaults.
Formula
Calculation
Weighted average rating score = Sum of (Amount x Rating score) / Total amount
Use an illustrative scale where AAA = 1, AA = 2, A = 3, BBB = 4, BB = 5 and B = 6. Suppose a portfolio of $100,000,000 holds $40,000,000 rated AA, $30,000,000 rated A, $20,000,000 rated BBB and $10,000,000 rated BB. The weighted sum is (40 x 2) + (30 x 3) + (20 x 4) + (10 x 5) = 80 + 90 + 80 + 50 = 300, and dividing by 100 gives a score of 3.0. A score of 3.0 corresponds to an A rating, so the portfolio's weighted average credit rating is A.Case study
Seen in the real world.
Oakridge Income Fund is an illustrative, fictional bond fund with $200,000,000 of assets. Its stated aim was to hold a portfolio with a weighted average rating of A or better.
Over a year several holdings were downgraded, and the manager also bought some BB-rated bonds to raise income. The risk team calculated the new weighted average score as 3.6, which sits between A and BBB.
In this illustrative story the manager reported the change to the board, which asked for a plan to return to the target. The fund sold $20,000,000 of its weakest holdings, and the score returned to 3.1. The lesson is that tracking the weighted average rating gives an early warning when credit risk drifts from its target.
Watch out
Common mistakes.
- Taking a simple average of the ratings, when larger holdings should count for more than smaller ones.
- Assuming the steps between ratings are equal, when the risk of default rises much faster at the lower end of the scale.
- Relying on the average alone, when a few weak holdings can be hidden inside a pool that looks strong overall.
Questions
People also ask.
Why is the rating converted to a number?
Letters cannot be averaged, so each rating is turned into a score, averaged with weights, and then converted back into a letter.
Who uses this measure?
Bond fund managers, investors in pooled loan structures, rating agencies and lenders that set limits on portfolio quality.
How often is it updated?
Usually monthly or whenever holdings or ratings change, because downgrades and new purchases can shift the average quickly.
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