Key Takeaways
- Weighted average of credit ratings by asset value.
- Converts ratings into numerical factors for risk.
- Used to gauge portfolio-level credit risk.
- Lower value indicates stronger credit quality.
What is Weighted Average Credit Rating?
The Weighted Average Credit Rating is a portfolio-level metric that quantifies overall credit quality by weighting each asset's credit rating according to its market or par value. This concept closely aligns with the Weighted Average Rating Factor (WARF), which converts qualitative ratings like AAA or Ca into numerical values to assess aggregate credit risk.
It is widely used to evaluate the creditworthiness of structured finance portfolios and investment funds, providing a single indicator of default risk exposure.
Key Characteristics
The Weighted Average Credit Rating offers a nuanced view of credit risk by considering both rating quality and exposure size. Key features include:
- Numerical Conversion: Translates letter grades into rating factors for quantitative analysis.
- Weighted by Exposure: Larger holdings have a proportionally greater impact on the overall score.
- Exponential Scale: Higher risk ratings like Ca carry exponentially larger factors, reflecting increased default probability.
- Portfolio Risk Assessment: Commonly applied to portfolios such as collateralized loan obligations and principle-protected securities regulated by the NAIC.
- Complementary Metrics: Often used alongside Weighted Average Maturity (WAM) and Weighted Average Spread (WAS) for comprehensive risk profiling.
How It Works
The calculation involves assigning a specific rating factor to each credit rating, where high-quality grades like AAA receive low numerical values, and lower grades such as Ca are assigned much higher values to reflect greater default risk.
These factors are then multiplied by the market value or par amount of each asset, and the sum is divided by the total portfolio value to produce the weighted average. This approach prioritizes risk exposure size, making it more accurate than a simple average.
Examples and Use Cases
Weighted Average Credit Rating is essential for investors and risk managers aiming to monitor portfolio credit quality effectively. Examples include:
- Airlines: Fixed income portfolios holding bonds from companies like Delta and American Airlines may use weighted credit ratings to evaluate default risk amid industry volatility.
- Bond Funds: Managers of fixed income funds such as BND regularly assess portfolio credit quality using weighted averages to align with investors’ risk tolerance.
- Low-Cost Index Funds: ETFs featured in best low-cost index funds guides may incorporate weighted credit ratings to track diversified bond indexes while managing credit risk.
- Bond Selection: Investors exploring best bond ETFs rely on weighted credit ratings to balance yield and credit safety in their portfolios.
Important Considerations
While Weighted Average Credit Rating provides valuable insight into portfolio risk, it is sensitive to the weighting methodology and the rating scale used. Excluding unrated or defaulted assets can skew results, so understanding the underlying assumptions is critical.
Incorporating this metric with other indicators like tail risk analysis and portfolio duration measures ensures a robust credit risk assessment. This approach helps you make informed decisions about your fixed income holdings and overall investment strategy.
Final Words
Weighted Average Credit Rating offers a precise measure of portfolio credit risk by weighting individual ratings by exposure size. To refine your risk assessment, calculate the weighted average for your portfolio and compare it against benchmarks or alternative investments.
Frequently Asked Questions
Weighted Average Credit Rating (WACR) is a metric that represents the overall credit quality of a portfolio by weighting each asset's credit rating by its market or par value. It closely aligns with the Weighted Average Rating Factor (WARF) used by agencies like Moody's to quantify portfolio credit risk.
WACR is calculated by assigning numerical rating factors to each asset’s credit rating and then computing a weighted average based on each asset’s market or par value relative to the total portfolio. This method emphasizes larger exposures to provide a more accurate risk assessment.
Rating agencies use WACR to capture the overall credit risk of diversified portfolios like CLOs and CDOs, as it provides a single, quantitative measure reflecting the likelihood of repayment by accounting for both credit quality and exposure size.
Unlike a simple average, which treats all assets equally, the Weighted Average Credit Rating accounts for the size of each asset’s exposure, giving more weight to larger holdings. This approach offers a more realistic view of portfolio risk.
Yes, in some calculations, defaulted assets are excluded to focus on performing assets. Moody’s, for example, calculates WARF independently using internal ratings data and may exclude defaulted securities to better assess ongoing credit risk.
Different agencies use varying scales; Moody’s assigns factors from 1 (Aaa) to 10,000 (Ca-C), while NAIC/S&P scales run from about 10 (AAA) up to 37,500 (D). These scales reflect the exponentially increasing credit risk for lower ratings.
WACR is widely used in structured finance products like CLOs, CDOs, and principle-protected securities to measure portfolio credit risk. Regulators and fund managers also use it to monitor and disclose credit quality.
WACR can be sensitive to weighting assumptions and may not capture all risk factors, such as those beyond credit ratings. It also often excludes non-rated or defaulted assets, which can affect the completeness of the risk assessment.
