TRC Corporation Rating Criteria Bond Fund Ratings Methodology

Introduction
Taiwan Ratings Corporation (TRC) is Taiwan's first credit rating agency. The company is a joint venture between Standard & Poor's, the world's leading credit rating agency, and the Taiwan Stock Exchange, the Taiwan Securities Central depository Company, China Credit Information Services, Joint Credit Information Center, the Over-the-Counter Securities Exchange, and the Securities and Futures Institute. This brochure identifies and addresses some of the specific factors considered by TRC in rating bond funds.

What is a bond fund rating?
A TRC bond fund rating is a current assessment of the overall credit quality of a fund's portfolio. The rating reflects the level of protection against losses from credit defaults and is based on an analysis of the credit quality of the portfolio of investment. In conjunction with this analysis, TRC also reviews counterparty risk, liquidity, management and the fund's legal structure (refer to rating methodology).

TRC does not assign a separate market risk rating with the credit quality rating. A bond fund market risk rating is an assessment of a fund's total return and net asset value variability to market risks such as interest rate risk.

A TRC bond fund rating has an "f" subscript (for fixed income) so as to clearly distinguish them from other types of ratings. The "tw" prefix indicates that these funds are rated using the Taiwan domestic rating scale and are not directly comparable to ratings assigned in the context of an international scale.

Definitions for TRC bond fund credit rating are as follows:

twAAAf
The bond fund provides extremely strong protection against losses from credit defaults relative to other Taiwanese bond funds.
twAAf
The bond fund provides very strong protection against losses from credit defaults relative to other Taiwanese bond funds.
twAf
The bond fund provides strong protection against losses from credit defaults relative to other Taiwanese bond funds.
twBBBf
The bond fund provides adequate protection against losses from credit defaults relative to other Taiwanese bond funds.
twBBf
The bond fund provides uncertain protection against losses from credit defaults relative to other Taiwanese bond funds.
twBf
The bond fund is vulnerable to losses from credit defaults relative to other Taiwanese bond funds.
twCCCf
The bond fund is extremely vulnerable to losses from credit defaults relative to other Taiwanese bond funds.

Funds are placed on CreditWatch when an event occurs or is expected to occur and additional information is required. For example, a bond fund may be placed on CreditWatch as a result of a change in investment approach or significant downgrades in commonly held securities. CreditWatch designations may be "positive", indicating a rating may be raised or "negative", indicating a rating may be lowered. "Developing" is used for unusual situations where future events are so unclear that a rating may potentially be raised or lowered.

Credit ratings are not a recommendation to purchase, sell, or hold a financial obligation, as ratings do not comment on market price or suitability for a particular investor. Ratings are based on current information furnished to TRC by the fund management company, the portfolio manager or obtained by TRC from other sources it considers reliable. TRC does not perform an audit in connection with any rating and may, on occasion, rely on unaudited financial information. TRC does not guarantee the accuracy of the information relied upon in assigning ratings.

Use of a bond fund rating in a prospectus or in marketing material is permitted. However, the full rating, together with a summary of the rating definition, should be included in the documents.

The benefits
The dynamic expansion of the mutual funds industry has confronted investors with an overwhelming number of investment options. Choosing the right fund to meet investor's income and capital needs has become increasingly difficult. In this environment, TRC credit information provides clear benchmarks for decision making. Ratings will be especially useful to investors governed by specific policy guidelines regarding the credit quality of their investments.

Ratings will also provide fund management companies with a key marketing tool, allowing them to differentiate their products in terms of risk, and target investors needs more accurately. For example, ratings will allow fund management companies to differentiate between low risk funds, designed to preserve capital and limit downside risk, and the higher risk growth funds.

Increasing competition, especially from foreign banks and fund management groups, is making fund managers look at different ways to sell their products. Over time, ratings will become and important strategic marketing tool in enhancing client service.

Rating methodology

Credit quality
The most important analytical task in completing a bond fund rating is determining the credit quality of the individual securities held, The credit quality of investment assets will largely be based on an assessment of their default risk, which will be derived from TRC credit ratings or confidential credit assessments. In general, the rating assigned to a fund cannot be higher than the combined quality of the assets held.

Counterparty risk
TRC looks at the counterparties to transactions, such as custodians and providers of repurchase agreements (repos). The concern is that a counterparty default could cause an economic loss to the fund, When evaluating a repurchase agreement, TRC focuses primarily on the credit quality and structural soundness of the transaction. To ensure that repurchase agreements are properly secured, TRC looks to see that the fund has taken all the necessary steps to maintain a first perfected security interest in any repo securities. As a general guideline, TRC views all investments relating to repurchase agreements as assets of the fund.

Liquidity
The liquidity of a portfolio is also of critical importance in determining market price exposure, because the degree of liquidity can affect the market value of investments. TRC takes into consideration the types of investments, their maturity structure and diversification. It is expected that the higher rated bond funds will have greater exposure to the more liquid forms of investments, such as government securities.

Portfolio manager evaluation
Essential to any analysis of a managed portfolio is an understanding of the portfolio manager. The focus of this assessment is on the portfolio manager's ability to implement a portfolio strategy that is consistent with the fund's stated investment goals and objectives. Portfolio managers should be familiar with the redemption patterns of their investor base, so as to manage cash flow volatility.

Fund management company assessment
TRC's analysis is also sensitive to the quality of the related fund management company. While the fund is a legally distinct entity, experience suggests that public confidence can be impacted by the financial standing of the related fund management company. TRC closely examines the group's organizational structure, the size and capabilities of its research staff, track record in portfolio management, operating procedures and internal controls. A fund management company should have internal controls that clearly segregate the operations of the fund from the rest of the group.

Legal structure
TRC expects that all funds will have an appropriate and approved trust deed, established in accordance with Securities and Futures Commission (SFC) regulations and requirements. The assets of the fund must be for the benefit of unit holders and segregated from any claims by creditors or other parties.

Industry characteristics
The criteria take into consideration the special characteristics of the Taiwan bond fund industry, In particular, TRC examines the extensive use of repurchase agreements in the absence of an active secondary bond market, and the influence of tax driven investors on the maturity profiles of funds. When evaluating a fund's credit quality, TRC looks at the underlying securities used in repurchase agreements. The credit quality of the counterparties to the repurchase agreement is also examined. More emphasis is placed on liquidity requirements because of the relatively short maturity profiles of Taiwan bond funds.

Information requirements

The following is some of the key information required for the rating analysis:

Documents

  • Prospectus or information memorandum
  • Trust deed
  • Custodian agreement
  • Repurchase agreement
  • Guarantee agreement

Financial information

  • Audited financial accounts of the fund for the past five years (if applicable)
  • Audited financial accounts of the fund management company for the past five years (if applicable)

Statistical information

  • Fund's growth pattern for the past five years ( if applicable)
  • Current list of portfolio holdings, including repurchase agreement securities
  • Current portfolio maturity distribution
  • Number of unit holders, and percentage of fund held by each of the 10 largest unit holders.
  • Subscription and redemption history on a monthly basis for the past five years ( if applicable)
  • Unit price of the fund on a monthly basis for the past five years ( if applicable)
  • Average yield per annum on a monthly basis for the past five years ( if applicable)

General information

  • Biographies and organizational chart for key employees (chief executive officer, Chief investment officer, fund manager and senior research staff)
  • Policies regarding internal controls and operating procedures
  • Policies regarding the fund's investment strategies

The rating process

TRC will assign a rating, only when the fund management agrees to provide the necessary portfolio information on a timely basis. The rating process begins when TRC receives an executed Rating Agreement Letter, requesting to have a particular fund rated. At this point, the analyst assigned to the fund asks for certain pertinent information regarding the fund.

Upon analysis of the information, the analyst schedules a management meeting with fund officials. The analyst next discusses the fund with a rating committee composed of senior TRC and Standard & Poor's Managed Fund analysts. The committee examines all relevant information found in the rating process. Following the analyst's rating presentation, the committee votes on a final rating.

If the proposed rating does not meet the fund's expectations the fund may appeal. During the appeal process, TRC refrains from publishing the rating until it reviews any new information the fund makes available. However, TRC does not guarantee that the additional information will alter the rating committee's decision.

Surveillance
Once a rating is issued, TRC will continuously monitor the fund and send out monthly surveillance forms. This is so as to ensure that any changes in the portfolio or the fund management's operating policies do not alter the fund's rating. TRC also conducts a yearly management review and portfolio strategy meeting to review any changes made during the year.


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