The Reserve Bank of India (RBI) has proposed using the movement in equity prices as part of a larger mechanism that can serve to give early warning signals of a potential default in a stressed company.
“Though all equity movements may not be of relevance for bond valuations, since bonds are superior in terms of claim hierarchy, they still present an early sign of distress,” the apex bank said in its 20th Financial Stability Report (FSR). “Therefore, it may be useful as an early warning mechanism to convert equity prices to an imputed distance to default measure to which the actual bond prices should be compared.”
Taking the case of a defaulting subsidiary of a core investment company, the FSR pointed out that equity prices showed resilience even after the subsidiary was classified as ‘default’. It attributed the ability of equity prices to withstand the ‘default’ tag to the fact that the debt was a ‘structured obligation’, backed by other underlying assets.
The report says equity prices may also be used to determine ‘intermediate’ rating action, but says one needs to be cautious about the extent they are used for such a purpose.
“While the current analysis of using equity prices as an early warning signal only explores the case of a default, it can be useful in determining intermediate rating transitions. Such an approach is not without criticism, since adjusting portfolios based on imputed ratings’ migration will entail false signals and over-reactions,” the report said.
“Hence, to what extent such prices may be internalised for market valuation of debt instruments or prudential action is a debatable point,” it added.
However, given the illiquid nature of debt markets, the report argued that an active equity price can serve as the only source of emerging information for all stakeholders including rating agencies.
“A prudential valuation plan for debt may be useful to take such emerging feedback into consideration,” the report noted.
According to market participants, rating agencies need to create a system where they can give more leading indicators, so that investors are not caught off-guard with sudden spurt of multiple rating downgrades as was seen following recent debt market crisis.