Morningstar Taxable Fixed Income Categories – Where Do CLOs Fit In? 

Morningstar is a publicly-traded financial services company that was originally founded in 1984 to help investors evaluate investment opportunities and assess risks associated with these investments in a systematic, quantifiable way. Today, Morningstar is a US$10 billion global company that offers a suite of research products that cover mutual funds, stocks, exchange-traded funds (“ETF”) and bonds. 


One of the key features of Morningstar research is its high-level summary reports that provide diagnostics such as: i) performance metrics versus benchmarks ii) segmentation of key risk factors and iii) proprietary ratings of each investment relative to its peers. For taxable bond fund investments (Table 1), Morningstar divides the asset class into twenty-one distinct groupings that range from Short Government, Intermediate Core Bond, Bank Loan, High Yield to Emerging Markets Local Currency. There is also a separate classification for non-taxable bonds.   


Table 1: Morningstar Category of Taxable Bond Funds and Characteristics


Morningstar Category

Category Reference Index

Debt Types (Government / Corporate / Securitized)

Coupon Type (Fixed / Floating)

Broad Ratings Category (Investment Grade / Non-Investment Grade)

Modified Duration

Long Government

Barclays US Government Long TR USD

Government

Fixed

Investment Grade

>6 Years

Intermediate Government

Barclays US Government TR USD

Government

Fixed

Investment Grade

3.5-6 Years

Short Government

BBgBarc US Govt 1-3 Yr TR USD

Government

Fixed

Investment Grade

1-3.5 Years

Inflation Protected Bond

Barclays US Treasury US TIPS TR USD

Government

Fixed

Investment Grade

>6 Years

Long Term Bond

Barclays US Govt/Credit Long TR USD

Government / Corporate

Fixed

Investment Grade

>6 Years

Intermediate Core Bond

Morningstar US Core Bd TR USD Hdg

All

Fixed

Investment Grade

3.5-6 Years

Intermediate Core Plus Bond

BBgBarc US Universal TR USD

All

Both

Both

3.5-6 Years

Short Term Bond

BBgBarc US Govt/Credit 1-3 Yr TR USD

All

Both

Investment Grade

1-3.5 Years

Ultrashort Bond

Barclays Govt/Corp 1 Yr Duration TR USD

All

Both

Investment Grade

1-3.5 Years

Bank Loan

S&P/LSTA Leveraged Loan TR

Corporate

Floating

Non-Investment Grade

3.5-6 Years

Stable Value

Morningstar Cash TR USD

Government

Both

Investment Grade

<1 Year

Corporate Bond

Barclays US Corp IG TR USD

Corporate

Both

Investment Grade

>6 Years

Preferred Stock

BofAML Preferred Stock Fixed Rate TR USD

Corporate

Fixed

Non-Investment Grade

>6 Years

High Yield Bond

ICE BofAML US High Yield TR USD

Corporate

Both

Non-Investment Grade

3.5-6 Years

Multisector Bond

Barclays US Universal TR USD

All

Both

Both

>6 Years

World Bond

BBgBarc Global Aggregate TR USD

All

Both

Both

>6 Years

World Bond-USD Hedged

BBgBarc Global Aggregate TR Hdg USD

All

Both

Both

>6 Years

Target Maturity

Barclays US Agg Bond TR USD

All

Both

Investment Grade

>6 Years

Emerging Markets Bond

JPM EMBI Global Diversified TR USD

Government / Corporate

Both

Investment Grade

>6 Years

Emerging-Markets Local-Currency Bond

JPM GBI-EM Global Diversified TR USD

Government / Corporate

Both

Investment Grade

>6 Years

Nontraditional Bond

Morningstar US Core Bd TR USD Hdg

Corporate

Both

Investment Grade

>6 Years


For each of its taxable bond sub-categories, Morningstar defines a set of criteria that supports the rationale for each grouping. For example, a “Bank Loan” bond ETF is described as portfolios that “primarily invest in floating-rate bank loans and floating-rate below investment-grade securities instead of bonds”.1 The ETF ‘AAA’, for instance, is presently categorized by Morningstar under “Bank Loan”. However, we contend that the ETF AAA should be categorized differently. 


Table 2: Ticker AAA Portfolio Characteristics


Ticker

Debt Types (Government / Corporate / Securitized)

Coupon Type (Fixed / Floating)

Modified
Duration

AAA

Securitized

Floating

1-3.5 Years


Differences to Consider

The classification of ‘AAA’ under “Bank Loans” seems appropriate in many ways as the ETF has some of the general characteristics of a bank loan. In fact, the underlying assets of ‘AAA’ are derived from bank loans extended to corporate credits with floating-rate coupons. 


However, there are some important distinctions that could suggest that Morningstar’s classification may be off the mark. One key difference is the credit ratings of the underlying assets. In many cases, a conventional bank loan fund will use the S&P/LSTA U.S. Leveraged Loan 100 Index as a benchmark, which is an index that is designed to reflect the performance of the largest facilities in the leveraged loan market. With this, all assets are generally senior secured with a minimum initial spread of LIBOR + 125 bps and a term of at least one year.2 


In contrast, all assets included in ‘AAA’ must be AAA-rated (or equivalent) collateralized loan obligations (“CLO”) (or cash) per fund guidelines. The rationale for AAA-rated CLOs is largely predicated on loss mitigation features on first priority positions with an enhanced structural repayment mechanism that contributes to the highest credit rating. Another way to put this is that a AAA-rated asset is likely to face the least potential for loss of principal under some type of market stress. 


Upon a more detailed review, ‘AAA’ appears to share most in common with attributes of Morningstar’s “Short Term Bond”; and some features of “Intermediate Core Bond”. According to Morningstar, a “Short-Term Bond” portfolio invests “primarily in corporate and other investement-grade U.S. fixed income issues…typically hav[ing] durations of 1.0 to 3.5 years”3; while an “Intermediate Core Bond” ETF would include portfolios that “invest primarily in investment-grade U.S. fixed-income issues including government, corporate, and securitized debt, and hold less than 5% in below-investment grade exposures. Their durations…typically range between 75% and 125% of the three-year average of the effective duration4 of the Morningstar Core Bond Index”.5 


From a duration standpoint, ‘AAA’ is most closely aligned with a “Short-Term Bond” strategy. The shorter duration offered by “Short-Term Bond” portfolios is consistent with ‘AAA’. Moreover, the very high credit quality of the the underlying assets of ‘AAA’ share many similarities with the composition of a “Short-Term Bond” portfolio. An “Intermediate Core Bond” strategy permits a fund to invest in securitized debt that are almost exclusively investment grade rated, which bridges it to ‘AAA’. However, an “Intermediate Core Bond” strategy tracks the Barclays U.S. Aggregate Bond Total Return Index6, which broadens the universe of potential assets than the pool that is permissible for ‘AAA’. 


In summary, Morningstar’s nomenclature and rating system is highly useful to help make investment decisions. In some cases, however, there is some imprecision to their definitions, which warrants some greater scrutiny to discern the clear risks and potential opportunities. We believe that from a credit-quality and duration basis, a “Short-Term Bond” characterization is most fitting for ‘AAA’.



Contact Information:

Todd Themistocles

Email: tthemistocles@altacfunds.com

Website: www.aafetfs.com

Phone: 917-535-5737


The fund's investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company, and once available a copy may be obtained without charge, by calling the Fund at 1-800-617-0004. Read it carefully before investing.

Investing involves risk. Principal loss is possible. Shares of any ETF are bought and sold at market price (not NAV), may trade at a discount or premium to NAV, and are not individually redeemed from the funds. Brokerage commissions will reduce returns. 

The Fund is also subject to the following risks: Collateralized Loan Obligations (CLOs) are generally backed by a pool of credit-related assets that serve as collateral. Accordingly, CLO securities present risks similar to those of other types of credit investments, including default (credit), interest rate and prepayment risks. In addition, CLOs are often governed by a complex series of legal documents and contracts, which increases the risk of dispute over the interpretation and enforceability of such documents relative to other types of investments. An increase in interest rates may cause the value of fixed-income securities held by the Fund to decline. The Fund may be subject to a greater risk of rising interest rates due to the current period of historically low rates and the effect of potential government fiscal policy initiatives and resulting market reaction to those initiatives. The Fund’s income may decline if interest rates fall. 

Performance data quoted represents past performance; past performance does not guarantee future results. Index performance is not illustrative of fund performance. One cannot invest directly in an index. Please call +215.287.1209 for fund performance.


A basis point (“bps”) is equivalent to one hundredth of one percent.


An investment grade is a rating that suggests a municipal or corporate bond issuance presents a relatively low risk of default given underlying credit metrics.


The London Inter-bank Offered Rate (LIBOR) is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks.


The AAF First Priority CLO Bond ETF (AAA) is distributed by Quasar Distributors, LLC.  No other products mentioned are distributed by Quasar Distributors, LLC.




1 Morningstar Category for Fund Definitions, April 2020, p. 39.

2 S&P Dow Jones Indices, S&P/LSTA U.S. Leveraged Loan 100 Index.

3 Morningstar Category for Fund Definitions, April 2020, p. 39.

4 Effective duration is a duration calculation for bonds that have embedded options. The effective duration helps calculate the volatility of interest rates in relation to the yield curve and therefore the expected cash flows from the bond.

5 Morningstar Category for Fund Definitions, April 2020, p. 38.

6 The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS, ABS and CMBS.