How reliable are credit ratings?

A spate of credit events hitting top rated issuers has put investors in a fix. Credit rating agencies have missed impending defaults in several companies including IL&FS, DHFL and Zee group, leading to sharp downgrades in ratings of instruments that were of supposedly high credit quality.

This has raised concerns about the utility of credit ratings, which often form the basis for investments by mutual funds and insurance companies. Are ratings not reflecting the actual financial position of the companies? How should investors interpret ratings in this scenario?

Lax standards
Credit ratings indicate the ability of a borrower to repay his obligations. However, there is a growing perception in India that credit rating agencies have been too charitable in rewarding ratings. For instance, the number of companies that enjoy AAA status in India is very high compared to other nations.

While India has 70-odd companies that are rated highest quality, only two companies in the US enjoy this distinction. No company in Germany and UK enjoys AAA rating. Among emerging countries, China has only 14 AAA-rated entities. This implies a gulf between credit standards in India and elsewhere. The exacting standards observed in other countries are missing among domestic agencies.

However, experts say these figures may not be strictly comparable. First, the bulk of the AAA rated entities in India are PSUs that enjoy quasi-sovereign status owing to their government parentage. Companies rated AAA in other countries mostly belong to the private sector. Further, the scale used by Indian rating agencies pertains to borrowing in rupee terms, whereas the international ratings are for borrowings in dollars or other foreign currency. The same domestic companies when rated on the global scale will have a lower rating.

Also Read: Who should be paying for the credit rating of bonds?

So, even Reliance Industries, which enjoys AAA status for domestic ratings, falls to Baa2 on the international scale. Also, rating for a company borrowing abroad is capped by the sovereign rating of that country. So even if a company enjoys AAA status in India, it is rated lower internationally owing to the Baa2 sovereign rating for India. The same is the case with foreign companies. R. Sivakumar, Head, Fixed Income, Axis Mutual Fund, points out that most companies in developed markets have racked up huge debts over time, which has prompted lower ratings for their debt instruments.

Bulk of bond issuers in India are rated high quality
Investors should look beyond the ratings
*includes B, BB, BBB, C and D rated companies. The figures pertain to long-term borrowings of rated companies in the BSE 500 universe.
Compiled by ETIG Database

However, Indian rating agencies have been caught on the wrong foot too often. The sharp divergence between the credit rating and the actual financial position is worrying. Experts say rating agencies have been found wanting. “Rather than pre-empt defaults, actions by rating agencies have often been post the credit event,” says Kunj Bansal, Partner & CIO, Acepro Advisors. “Large institutional investors have started taking ratings with a pinch of salt and begun setting up internal rating mechanisms to ascertain credit quality of issuers,” he adds.

Some feel that credit ratings in their current form offer little utility. “Credit ratings have been simplified to an extent where they have lost some relevance,” says Dhawal Dalal, Head, Fixed Income, Edelweiss AMC. “There are multiple dimensions to companies between sectors that cannot be truncated into a single letter. There is a need to dig deeper to ascertain true financial position of the issuer,” he adds.

However, there are some who feel these are stray instances and that rating agencies have by and large provided accurate reading of companies’ health. “My assessment is that Indian credit rating agencies are reasonably selective in the AAA and AA space. It is in the papers rated slightly above investment grade that agencies are a bit lax,” contends Sivakumar.

The consensus is that the conflict of interest in the business model of rating agencies has diluted the credibility of the rating mechanism. Since rating agencies are compensated by the issuers who raise debt, it has led to instances of company promoters shopping around for a favourable rating. Companies deserving no more than A rating have been awarded AA or higher.

Vikas Gupta, CEO and Chief Investment Strategist, OmniScience Capital, feels rating agencies have been found wanting but are constrained by the revenue model. “Rating agencies are largely to blame for the mess, but nothing will change until the economic incentives are not aligned properly. Rating agencies need to introspect,” he says. The malaise has prompted the regulator to consider overhauling the manner in which the business works—scrapping the issuer-pays model and moving to one where the investor pays.

Not a guarantee
It is critical that investors realise that credit rating is not a guarantee but simply an opinion of the rating agency. Experts say investors should not treat the credit rating as sacrosanct and avoid using it in isolation. These may be used as a starting point before digging deeper with other metrics.

While investing in bond funds, for instance, credit ratings can be used as a broad filter to identify quality schemes, which will give some comfort about the overall health of the fund, suggests Vidya Bala, Head, MF Research, FundsIndia. The diversified nature of exposure to bonds in a mutual fund ensures that risk from individual bonds will not affect the fund much.