Morningstar Calculated Fixed-Income Style Box Methodology

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1 ? Morningstar Calculated Fixed-Income Style Box Methodology Morningstar Research 15 April 2015 The Morningstar Style Box The Morningstar Style Box was introduced in 1992 to help investors and advisors determine the investment style of a fund. Different investment styles often have different levels or types of risk and can lead directly to differences in returns. The Morningstar Calculated Fixed-Income Style Box, introduced here, provides an intuitive visual representation of portfolio investment style in order to help investors both better understand their investments and achieve successful investment outcomes. Fixed-income investors face two primary types of risk. The first is interest-rate risk, which can adversely affect the value of the investment as well as the overall level of interest income generated. The second is credit risk, which reflects the probability of a creditor defaulting or a credit rating agency downgrading the bond. To model these risks, Morningstar classifies bond funds in its Fixed-Income Style Box according to two factors, interest-rate sensitivity and average credit quality. The measures of these two factors are Limited, Moderate, and Extensive for the modified duration of a fund's holdings and High, Medium, and Low average credit quality, based on credit ratings of bond holdings. The nine possible combinations of these individual characteristics correspond to the nine squares, or cells, of the Morningstar Fixed-Income Style Box. Average portfolio credit quality is displayed along the vertical axis and sensitivity to interest rates along the horizontal axis. Overview Understanding the Fixed-Income Style Box The model for the Fixed-Income Style Box is based on two primary determinants of fixed-income risk: interest-rate sensitivity and credit quality. Interest-rate sensitivity is measured in one of three categories, Limited, Moderate, and Extensive. Credit quality is also measured in one of three categories, High, Medium, and Low. These measures are combined to display a portfolio's modified duration and average credit rating as an overall representation of the fund's risk orientation given the interest-rate sensitivity and credit rating of bonds in the portfolio.

2 Page 2 of 14 Page 2 of 14 Exhibit 1 Morningstar Fixed-Income Style Box For Illustration Only. Portfolio-Average Style Box Cell Presentation The Fixed-Income Style Box consists of nine cells representing specific combinations of interest-rate sensitivity and credit quality. For any qualifying portfolio, each individual value is calculated and the portfolio is assigned to the cell that equals the representative factor categories. In this way, the risk style of the portfolio is clearly assigned to one of the nine possible factor combinations. This supports straightforward analysis by an investor. Fixed-Income Style Box Cell Definitions Exhibit 2 Fixed-Income Style Box Cell Positions and Definitions Cell Position Cell Definition 1 Limited Interest-Rate Sensitivity/High Credit Quality 2 Moderate Interest-Rate Sensitivity/High Credit Quality 3 Extensive Interest-Rate Sensitivity/High Credit Quality 4 Limited Interest-Rate Sensitivity/Medium Credit Quality 5 Moderate Interest-Rate Sensitivity/Medium Credit Quality 6 Extensive Interest-Rate Sensitivity/Medium Credit Quality 7 Limited Interest-Rate Sensitivity/Low Credit Quality 8 Moderate Interest-Rate Sensitivity/Low Credit Quality 9 Extensive Interest-Rate Sensitivity/Low Credit Quality

3 Page 3 of 14 Page 3 of 14 For example, a portfolio with moderate interest-rate sensitivity and medium credit quality is assigned cell 5 in the Fixed-Income Style Box: Exhibit 3 Portfolio Assignment to Style Box Cell 5 for Moderate Interest-Rate Sensitivity/Medium Credit Quality For Illustration Only.

4 Page 4 of 14 Page 4 of 14 Cell-Weighted Style Box Presentation An alternate presentation of the style box provides a more detailed representation of interest-rate and credit measures. Rather than calculating a single portfolio average value for each factor, which is then displayed in a single cell, the cell-weighted presentation displays the weighted percentage of the portfolio applicable to each individual cell. This additional level of detail allows investors to analyze credit and interest-rate risk with greater precision. In this view, the cell values will be calculated only for those holdings that have credit quality and interest-rate risk factors assigned, which will then total 100%. The cell-weighted style box presentation may be available in selected local products only. Exhibit 4 Portfolio Assignment to Style Box Cell 5 for Moderate Interest-Rate Sensitivity/Medium Credit Quality For Illustration Only. Thresholds for Determination In order for the measurements of the Fixed-Income Style Box to be relevant, Morningstar employs minimum threshold tests that establish levels for overall percentage of fixed-income holdings within a portfolio, the percentage of fixed-income holdings for which a credit score can be calculated, and the percentage of fixed-income holdings for which a modified duration can be calculated. Average Credit Quality will be generated for portfolios meeting requirements 1 and 2. Average Modified Duration will be generated for portfolios meeting requirement 3. The Fixed-Income Style Box will be generated for portfolios with both Average Credit Quality and Average Modified Duration. Requirement 1: Fixed-Income Share of Portfolio At least 25% of the portfolio by market value needs to be debt and debtlike instruments based on the Morningstar classification.

5 Page 5 of 14 Page 5 of 14 Requirement 2: Ratable Share of Fixed-Income Share At least 50% of the market value of debt and debtlike instruments needs to have a rating value. Requirement 3: Fixed-Income Share with Modified Duration At least 50% by market value of debt and debtlike instruments needs to have modified duration calculated. Inputs to the Fixed-Income Style Box Calculation of a Fixed-Income Style Box for a portfolio is dependent on being able to calculate the style box factors at a holdings level and then aggregate the holdings values to portfolio statistics. Holdingslevel calculations are based on use of credit ratings to determine credit quality and calculation of duration for interest-rate sensitivity. Interest-Rate Sensitivity The price of a bond is equal to the net present value of all future cash flows using an interest rate or yield. Interest-rate sensitivity measures the expected percentage change in market value of a bond in response to a small change in its yield. Thus, when the general level of interest rates rises, the specific level of interest on the investment becomes less valuable, resulting in a decrease in market value as it is discounted at a greater rate. This is described as an inverse relationship between bond prices and interest rates, or yields. Instruments that are more sensitive to changes in interest rates thus contain more specific interest-rate risk than those with less sensitivity. There are two primary factors that contribute to interest-rate sensitivity, the time to maturity or return of principal and the coupon rate being paid to the bondholder. Exhibit 5 Inverse Relationship Between Bond Prices and Interest Rates For Illustration Only. Modified Duration and Calculation For the Fixed-Income Style Box, interest-rate sensitivity is measured using a specific calculation called modified duration, which represents sensitivity as a factor based on the change in the value of an investment given a change in the level of interest rate used to calculate net present value. The interest-

6 Page 6 of 14 Page 6 of 14 rate change is generally agreed upon as 1 percent (or 100 basis points), and the sensitivity factor then represents a percentage change in value of the investment. In this way, modified duration is a relatively intuitive measure of sensitivity as it translates directly into a predicted percentage of change in value. [1] Macaulay Duration Modified Duration = 1 + YTM [2] Macaulay Duration = N t=1 t C N FV (1 + YTM) t + (1 + YTM) N P Where C = Coupon FV = Face value of the bond P = Price N = Periods to maturity t = Time to payment YTM = Yield to maturity Holdings Calculations Each holding is assigned a portfolio-weight factor by dividing the holding's market value by the total portfolio market value of all fixed-income holdings. This factor is then multiplied by the modified duration of the holding to generate a holdings-weighted duration factor. [3] Holdings-Weighted Duration Factor = Modified Duration of the Holding * Market Value of Holding / Total Market Value of Duration Instruments Aggregation to Portfolio Average The average modified duration of a portfolio is determined by aggregating the holdings-weighted modified duration factors of all applicable fixed-income holdings within the portfolio. [4] Average Modified Duration = n 1 (Holding Weighted Duration Factor) Interest-Rate Sensitivity Breakpoint Determination The last step of calculating the Fixed-Income Style Box portfolio interest-rate sensitivity is to assign the portfolio's average modified duration value to the appropriate sensitivity category. Morningstar has determined the following values correspond to the three categories of interest-rate sensitivity based on analysis of common market practice:

7 Page 7 of 14 Page 7 of 14 Limited sensitivity: < = 3.5 years Moderate sensitivity: > 3.5 and < = to 6.0 years Extensive sensitivity: > 6.0 years

8 Page 8 of 14 Page 8 of 14 Credit Quality Use of Ratings The use of credit ratings in fixed-income markets as indicators of credit quality or risk is longstanding and pervasive. Credit ratings are issued by independent organizations called credit rating agencies. The rating assesses the ability of the creditor (usually referred to as the issuer) to repay its debt, which is the fixedincome security being rated. While every fixed-income investment carries credit risk, not all are rated. However, use of ratings to calculate portfolio credit measures is well established and therefore is how the Fixed-Income Style Box credit quality scores will be generated. Meaning of Ratings Each rating agency uses a series of alphabetic symbols to communicate the specific credit quality/risk of a security. The primary meaning of a rating is the predicted ability for the repayment of the debt obligation on a timely basis. Each agency uses unique symbols and definitions, but there are striking similarities between agencies, and their scales can be directly mapped to each other. This allows for the interchangeable use of ratings issued by different agencies and the combination of ratings from multiple agencies. As mentioned previously, not all securities have a rating. It is not possible for Morningstar to accurately assess the credit quality/risk of nonrated securities. Therefore, they will not be included as inputs to credit quality calculations except for establishment of portfolio-level calculation thresholds. The exception to this rule will be for those instances where Morningstar can accurately determine that the holding is essentially similar to a rated security and that the rating can be deemed precisely comparable. In such a case, a rating value will be extrapolated from the rated security to the nonrated security. Ratings as Inputs The Fixed-Income Style Box credit quality is based on the ratings applicable to individual holdings in the portfolio. The ratings can be from any reputable credit rating agency. In cases where there is more than one rating available, they will be combined. Ratings as Outputs To maintain the inherent meaning of ratings as credit quality measures, the numeric credit values calculated by Morningstar will also be represented as ratings. Conversion/Transformation of Ratings Because virtually all ratings are alphabetic symbols, they do not directly lend themselves to calculation without first being transformed to a numeric equivalent. As noted previously, rating scales are different from one rating agency to another, but they do follow similar construction and use of symbols, with essentially equivalent meaning. This similarity supports the

9 Page 9 of 14 Page 9 of 14 assignment of numeric rating equivalents for alphabetic symbols and the combination of different rating agencies into combined rating scores. Morningstar maps ratings to a numeric scale with values from 1 to 27, with 1 being the least risky and 27 the most risky (equivalent of default). The mapping of rating symbol to numeric equivalent is done in a linear manner, as shown in Exhibit 6. Exhibit 6 Morningstar Credit Rating to Numeric Value Conversion Morningstar Credit Rating Numeric Value AAA 1 AA+ 2 AA 3 AA- 4 A+ 5 A 6 A- 7 BBB+ 8 BBB 9 BBB- 10 BB+ 11 BB 12 BB- 13 B+ 14 B 15 B- 16 CCC+ 17 CCC 18 CCC- 19 CC+ 20 CC 21 CC- 22 C+ 23 C 24 C- 25 Reserved 26 D 27 NR null

10 Page 10 of 14 Page 10 of 14 Certain Morningstar reports use a less granular display of ratings. For those existing reports, the conversion from numeral to symbol equivalent is as follows: Exhibit 7 Morningstar Credit Rating Category to Numeric Values Conversion - Alternative Morningstar Credit Rating Category Numeric Values AAA Greater than 0 to equal to 1 AA Greater than 1 to equal to 4 A Greater than 4 to equal to 7 BBB Greater than 7 to equal to 10 BB Greater than 10 to equal to 13 B Greater than 13 to equal to 16 Below B Greater than 16 to equal to 27 NR null Averaging of Multiple Values Ratings from any and all recognized and reputable rating agencies can and will be used to calculate the Fixed-Income Style Box. This promotes increased coverage of portfolio holdings as well as inclusion of the collective analysis and oversight represented by the rating agency community. In many cases, there will be ratings from more than one rating agency for a given portfolio holding. In such cases, the numeric values of the ratings for the holding will be averaged to generate a single rating score. This average numeric rating score will be used in calculating portfolio statistics that determine the Fixed-Income Style Box. Extrapolation All debt securities possess credit risk. Ratings are a highly useful method for assessing credit risk across the universe of outstanding debt securities. But in some cases, a particular debt security may not have an issued rating, which poses a problem for analysis of credit risk. In many cases, the source of payment for a debt security can be accurately and precisely identified as one with rated debt outstanding. In these cases, it is logical to conclude that the rating that is issued is measuring the same credit quality as is applicable to the nonrated security. In such cases, to the extent that Morningstar can make a clear and precise analysis of credit source, the issued rating will be assigned to the nonrated holding through a rating extrapolation process. Morningstar believes this approach will more accurately reflect the credit quality of portfolio holdings by minimizing the percentage of nonrated holdings.

11 Page 11 of 14 Page 11 of 14 Portfolio Calculations Once ratings have been converted to numeric values, they can be assigned to holdings and incorporated into portfolio calculations. Each holding is assigned a portfolio-weight factor by dividing the holding's market value by the total portfolio market value of all fixed-income holdings. This factor is then multiplied by the average numeric rating value of the holding to generate a holdings-weighted credit quality. [5] Holdings-Weighted Credit Quality = Numeric Rating Value of the Holding * Market Value of Holding / Total Market Value of Rated Instruments Once the holdings-weighted credit quality has been computed, it is then used to calculate portfolio-level statistics. For the Fixed-Income Style Box, a numeric average credit quality value is determined by summing the holdings-weighted credit quality: [6] n Portfolio Numeric Average Credit Quality = 1 (Holdings Weighted Credit Quality ) The Portfolio Numeric Average Credit Quality is then converted to a letter symbol using Exhibit 7. Credit Quality Breakpoint Determination Assignment of the portfolio average credit quality in the Fixed-Income Style Box is determined by where the score falls relative to the category value parameters. The three levels of Fixed-Income Style Box credit quality correspond to a range of numeric portfolio average credit quality values and can then be converted to an equivalent rating symbol. Exhibit 8 Fixed-Income Style Box Credit Category to Numeric Value and Average Credit Quality Symbol Conversion Credit Category Numeric Value Average Credit Quality Symbol High 0 to 4 AAA to AA- Medium Greater than 4 to 10 A+ to BBB- Low Greater than 10 BB+ or lower

12 Page 12 of 14 Page 12 of 14 Style Box Cell Calculations Once holding and portfolio calculations are completed, they must be converted into style box equivalents. As noted previously, there are two presentations of the Fixed-Income Style Box, portfolioaverage and cell-weighted. The style box consists of a nine-cell matrix, and each cell has boundary values for the two factors represented. While the factors are defined as specific descriptive terms, they must be assigned numeric values in order to complete the calculation processes and construct the style box presentations. Exhibit 9 Fixed-Income Style Box Cell Positions and Breakpoints Cell Position Cell Definition Interest-Rate Sensitivity Range Average Credit Quality Range 1 Limited Interest-Rate Sensitivity/ High Credit Quality 0 to 3.5 AAA to AA- 2 Moderate Interest-Rate Sensitivity/ High Credit Quality Greater than 3.5 to 6.0 AAA to AA- 3 Extensive Interest-Rate Sensitivity/ High Credit Quality Greater than 6.0 AAA to AA- 4 Limited Interest-Rate Sensitivity/ Medium Credit Quality 0 to 3.5 A+ to BBB- 5 Moderate Interest-Rate Sensitivity/ Medium Credit Quality Greater than 3.5 to 6.0 A+ to BBB- 6 Extensive Interest-Rate Sensitivity/ Medium Credit Quality Greater than 6.0 A+ to BBB- 7 Limited Interest-Rate Sensitivity/ Low Credit Quality 0 to 3.5 Below BBB- 8 Moderate Interest-Rate Sensitivity/ Low Credit Quality Greater than 3.5 to 6.0 Below BBB- 9 Extensive Interest-Rate Sensitivity/ Low Credit Quality Greater than 6.0 Below BBB- Portfolio-Average Style Box In this presentation, the average portfolio values for interest-rate sensitivity and credit quality are combined to assign the portfolio to a single cell within the style box that represents the average sensitivity value of the portion of the portfolio that can be calculated. Cell-Weighted Style Box In this presentation, the risk sensitivity of the portfolio can be more precisely communicated by assigning holdings to specific cells and then displaying the cell totals as a percentage of the overall portfolio. All holdings applicable to a specific cell are summed and then divided by the total of all portfolio holdings that can be assigned a cell value. It is important to note that only holdings with both a credit value and a duration value will be represented in this perspective. This is different from the methodology for portfolio average values where the credit and duration values are calculated independently from one another. [7] Cell-Weighted = (Total of Specific Cell Holdings Value)/ (Total of All Cell Holdings Value) The rescaled portfolio cell-weighted calculation presents the value of each cell as a percentage of the total fixed-income portion of the portfolio for which both factors are calculable. Cell percentages will add up to 100%.

13 Page 13 of 14 Page 13 of 14 Summary The Morningstar Fixed-Income Style Box is a tool that presents relevant portfolio risks and sensitivities for investors in a clear, intuitive manner. A number of changes have been implemented in this revision: Ratings from multiple rating agencies can be combined and averaged. Ratings will be converted to a linear numeric scale ranging in value from 1 (highest quality) to 27 (lowest quality). Nonrated holdings will not be used as inputs to portfolio calculations for the style box except when determining thresholds. Where possible, ratings inputs will be used to generate extrapolated ratings values for input values to portfolio calculations. The Morningstar Calculated Fixed-Income Style Box offers investors an objective, intuitive tool for assessing primary risks for fixed-income investors and for making comparisons between investment alternatives.

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