How Reliable Are Credit Rating Agencies?

How Reliable Are Credit Rating Agencies?

Last updated: 16 Jul, 2020 | 03:40 pm

How Reliable Are Credit Rating Agencies?
  • Credit rating agencies such as CRISIL, ICRA, CARE ratings etc exist to provide an independent evaluation of creditworthiness of a company issuing a bond.
  • Investors and institutions rely on these agencies’ ratings to plan their portfolio and investments.
  • Indian companies have recently had a rough time and have been getting downgraded at the highest pace ever. 
  • Close to 3,936 firms have been downgraded since January 2020 while 593 were upgraded in the same period as per data from S&P Global Ratings.
  • A downgrade of a bond paper usually results in higher selling as investors realign their portfolio given the natural risk-averse nature of the bond markets.
  • Many institutions are mandated by an IPS (investment policy statement) to not invest below a certain credit rating. Therefore, as soon as a downgrade happens below that threshold, to adhere to that IPS a mass selling starts which sharply increases the YTM of the bond.

How Reliable Are Rating Agencies?

  • Rating agency downgrades in many cases have been after the fact. Many a time these agencies even completely miss the existing stress in a company. 
  • Case in point- DHFL and ILFS, where an AAA-rated company went through severe bouts of stress without any rating changes. 
  • 'One of the best predictors of stress on a bond paper is the movement in price and consequently the YTM of bonds. ‘Market knows best’ is a core tenant of efficient market theory.'
  • As soon as there is even the slightest hint of stress in a company,  you will see the YTM rising. Rating actions often come after YTM’s have already surged.
  • However, a fact still remains that post a rating action, the knee jerk reaction of institutions adjusting their positions causes the YTM to increase even further. 

Let’s see this via a few recent examples:

Indiabulls Housing Finance, a previously AAA-rated company, witnessed its YTM increase from 9% to 26% in a span of 1 year.

CRISIL rating agency downgraded Indiabulls Housing Finance rating from AAA to AA+ on 10th September 2019 and from AA+ to AA on 7th Feb 2020.

  • Till May 2019: The bond was trading at an average YTM of 9.6%.
  • In June: it started increasing and touched a high of 13% till 10th September 2019, when an actionable decision was taken by the rating agency. 
  • This shows a YTM increase of almost 3.5% (price indicated that stress had started building in the company) before any action by the rating agency was taken.
  • Post the downgrade, YTM reached a high of almost 23.5% till November 2019 and then settled at an average of 15% till Feb 2020. 
  • At this point, the rating agency further downgraded the company to AA. However, the yields remained almost the same for the month of Feb. The tumble started in March when COVID 19 pandemic started progressing. The yields reached a high of almost 26%.

A similar pattern can be observed with SREI Infrastructure Finance Company where Brickwork rating agency downgraded it from AA to A+ on 10th September 2019. The yields had been continuously increasing without any rating action till that point.

Below is Shriram Transport Finance Company, where the YTM has shot from 10% to 15% in a span of 6 months without a rating change

The only action was an outlook revision that was done by CRISIL on 6th May 2020, when YTM’s had already shot up significantly. The Rating of the company still stands at AA+ even though there is significant stress in the company. 

In Contrast, below is the YTM movement of Tata Capital Financial Services where the YTM has moved almost in line with G-sec as the company has strong fundamentals and liquidity. The YTM is predicting exactly that.

INDmoney Analysis

  • Never substitute high YTM with high Returns. It is just the opposite. A high YTM is usually indicative of a high probability of default, where an investor will not only not earn money but his principal is also not safe.
  • Current economic factors signal high levels of risk to businesses and the effects of these risks will be particularly acute in sub-par bonds. 
  • FII’s have been selling out of India’s debt markets with net outflows in April, May and June even as Equities have seen inflows.
  • Our exhaustive bond database tracks and covers bond pricing, ratings, outlooks and probability of defaults across the bond market. 
  • Our notifications will let you know when you are exposed to dangerous papers across your investments. 
  • The risk to return on any sub-par debt is not favourable right now. Do not chase yields that riskier bonds may offer, as it is better to err on the side of caution in this economic environment.

'INDmoney uses a probability of default based debt analysis model. The model looks at the internal stress of a company and sends an alert as soon as risk increases.'

As moratorium starts getting lifted, we expect a sharp decline in credit quality of a lot of companies. The number of downgrades are expected to increase.

We advise you to invest only in High-Quality AAA-rated companies.

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