FINALLY, BOND FUNDS MAY POST GRADES: NASD CONSIDERS ADS THAT WOULD TOUT CREDIT STAMP BY MOODY’S, S&P AND OTHERS

Bond mutual funds may soon be allowed to use credit agency ratings in their marketing, says John Ramsay, vice president and general counsel of the National Association of Securities Dealers.

The association, which regulates securities and mutual fund advertising, is reviewing the last of numerous public comment letters called for by the Securities and Exchange Commission on a proposal to permit prospectuses to use the ratings over an 18-month trial period.

“We hope to have something adopted in the next few months,” says Mr. Ramsay. “I’m not aware of any major concerns that the SEC has that haven’t been addressed at this point.”

Fund companies (all that were called declined comment) will believe it when they see it. The proposal, first made in 1996, has been bogged down in debate ever since.

These ratings are different from, say, the stars issued by Morningstar Inc., the Chicago fund tracking firm that bases its analyses on past performance. Bond credit rating agencies, like New York-based Moody’s Investor Services Inc., assess the volatility of the fund by analyzing the credit standing of its individual holdings.

Credit rating companies proposed the system because in 1994 the bond market collapsed and novice investors holding such funds were shocked to learn that unlike with an individual bond, their principal was at risk. Some financial industry leaders were looking for a way to help investors understand that risk better.

But consumer advocates and regulators fear the ratings could be used by fund companies as a marketing gimmick, and thus mislead investors more than help them.

The SEC, NASD and even the mutual fund industry’s Investment Company Institute have long expressed concern because such ratings are forward-looking, in that they measure the chances that the bonds in the portfolio will default.

The Consumer Federation of Americ, meanwhile, has questioned the way credit-rating companies do business: by charging fund managers who seek ratings. Moody’s, for example, charges between $12,500 and $17,000 for a management evaluation plus an additional $7,000 to assess each portfolio.

“That these ratings are being bought and sold creates an enormous conflict of interest,” argues Barbara Roper, director of investor protection at the Consumer Federation of America.

She suggests a fund company could pressure a credit rater to improve the fund’s ratings or else lose its business. Conversely, she says, a rating company might pressure a fund into paying a premium for higher ratings if the ratings come to be viewed as a marketing necessity.

The qualitative analysis that goes into a fund’s credit rating is yet another concern. Detractors argue that Moody’s and its competitors, such as Standard & Poor’s, vary in their research methodology.

kicking the tires

Douglas Rivkin, a senior credit officer at Moody’s, says the qualitative methods are important so credit analysts can “kick the tires, see that a fund has competent managers running its business.” Mr. Rivkin also says the firm must charge fund companies to make a living.

Ms. Roper argues that investors benefit only if the ratings are as objective — and transparent — as possible. “Only then can you tell if (the credit rating company) is applying information uniformly and consistently.”

Still the SEC proposal in its current form addresses all concerns, says Mr. Ramsay. For instance, one condition stipulates that to use a risk rating in marketing materials, it must be called a “volatility” rating. It must also be incorporated into a narrative, surrounded by disclaimer language so investors understand that the rating is no guarantee of future performance. Finally, the rating must be based on objective, quantifiable data.

The NASD isn’t asking that companies like Moody’s throw their qualitative methodology out the window, says Mr. Ramsay. It just wants the ability to replicate the ratings process.

“We want to be able to look at the data, plug it in ourselves and see how they arrived at the result that they did,” he says.

Mr. Rivkin calls Moody’s method of rating companies both quantitatively and qualitatively “very fair already.”