Don't go by credit rating alone, consider default analysis, performances

The recent defaults by IL&FS and its subsidiaries have shaken investors’ faith in the ratings provided by credit rating agencies. The ratings of its debt instruments plunged from AAA to D (default) within a few months. While investors who invest directly in bonds cannot ignore ratings, they do need to take a few additional precautions. 

Read the credit report: Before investing in a debt instrument, go to the concerned rating agency’s website and obtain the credit report on the borrower. This report contains the rating, which indicates where the company stands regarding  probability of repaying its dues (see box). “An investor who wants to know a company’s strengths and weaknesses and the key drivers of its ratings will find that information in the report,” says Anjan Ghosh, chief rating officer, ICRA.

Credit reports also contain the rating outlook. “An outlook indicates the direction of the rating and tells you what the rating agency thinks will happen to the rating in the future,” says Revati Kasture, senior director, Care Ratings. There are three types of outlook — stable, positive, and negative. If a company has a stable outlook, it means that the agency expects the rating to remain the same at the next review. If the outlook is positive, the agency expects the credit profile to improve, in which case the rating could be upgraded, and so on.

A credit report also contains a snapshot of the company’s finances, and parameters like profitability, liquidity, and solvency. The credit report also contains the company’s rating history. “It gives investors a sense of the direction – upward or downward - in which a company’s rating has moved in the past,” says Kasture. 

Look up performance parameters: Investors should look up a metric called credit default analysis, available on rating agencies’ websites, to compare performance vis-a-vis their peers. The default rate provides the number of defaults that have happened for different rating categories (AAA, AA, etc) over a particular period. Suppose that one agency has a credit default rate in the AA category of 0.9. It means that nine out of 1,000 AA instruments rated by it have defaulted over the past three years. A lower default rate is better. “The default rate tells you how well a rating agency is doing its job. By comparing default statistics across rating agencies, you can get a good estimate of which agency’s ratings are more reliable,” says Gurpreet Chhatwal, president, CRISIL Ratings. Default rates of a rating agency should go down as you move up the rating scale. 

Investors can also compare rating agencies using the stability metric. If 100 companies were rated AAA three years earlier and 98 are still rated AAA after that period, it indicates 98 per cent stability. “Higher the stability of ratings, better the performance of a rating agency, since it indicates that its ratings are less volatile,” says Kasture. Ghosh adds that stability of rating also needs to be correlated with rating level. “Higher-rated instruments should be more stable,” he says. 

Crisil discloses another metric that shows the intensity of rating action for entities rated A and above. “We call a downgrade of more than two notches in A  category and above as a high-intensity rating action. A large proportion of high-intensity rating action indicates that the rating agency is not doing its job properly,” says Chhatwal. He adds that if an agency has been tracking a company, it should reflect the changes in the company’s position regularly, thereby eliminating the need for high-intensity rating action.

Compare ratings across agencies: When a company launches a public issue, it is required to disclose two ratings. But it may have other debt instruments for which it would have been rated in the past. It may have an AA+ rating in the bond that it is issuing, but it may AA or AA- rating on its other bonds. “The company is not obliged to disclose this information in the public issue document. Investors should go to the websites of different rating agencies and check the ratings of all existing instruments. They should take cognisance of the lowest rating as well, as institutional investors do,” says Chhatwal.

Diversify your bets: The rating system suffers from a weakness. “Companies pay for the ratings, which creates an inherent conflict of interest. If one agency rates a company poorly, it will go to another. So long as ratings are paid for by companies, you cannot rely on them entirely,” says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor (RIA). Even regulators ask banks and mutual funds to do their own due diligence as well.     

Retail investors investing directly need to take precautions. “If you are investing in the debt papers of a highly reputed corporate house, then you may go by ratings alone. In the case of more debatable names, you need to do additional due diligence,” says Nilesh Shah, managing director, Kotak Mahindra Asset Management. Shah adds that he would avoid investing in highly leveraged companies. 

Raghaw warns of the higher risk that NCDs of non-banking financial companies carry. “Their tendency to borrow short-term money and lend for the long-term means that any failure to roll over a short-term debt paper can result in a default,” he says. Shah suggests that retail investors unable to assess risks themselves should take the mutual fund route. “They offer the advantage of diversification. While some funds did have exposure to IL&FS, remember that this was limited to a few percentage points,” says Shah. Says Amit Tripathi, chief investment officer-fixed income investments, Reliance Mutual Fund: "Due to extensive research, market intelligence, business and financial channel checks, we do have an information edge." He suggests going with a fund house having a strong credit research team with adequate number of feet on the ground to do the due diligence.