Investors trip on ratings downgrades

Sebi's attempt to plug loopholes may help investors deal with sudden changes in credit ratings

In the past couple of years, debt fund investors have found themselves in sudden and deep trouble when credit rating agencies (CRAs) have made abrupt multi-notch downgrades of companies. Investors in Franklin Templeton Mutual Fund’s debt funds, for example, saw a sharp erosion in the net asset values (NAVs) due to the fund house’s exposure to Jindal Steel and Power (JSPL)’s bonds. The bonds of JSPL saw sharp downgrades in less than two weeks’ — from AA- to BB+, and then, to D. Many investors, worried about the schemes’ future performance, chose to exit. There have been many other fund houses who have found themselves in trouble when their investments in companies faced sudden downgrades. 

Credit ratings are important because both retail and institutional investors take critical investment decisions based on them. If those ratings don’t reflect a company’s true ability to service its debt, investors end up paying a price. In several cases involving Amtek Auto, Ballarpur Industries, and most recently, Reliance Communications (RCom), CRAs have been found wanting. Market regulator Securities and Exchange Board of India (Sebi) has come out with a circular recently that aims to tighten the rules for CRAs.

CRAs found wanting: In the RCom case, CRAs downgraded the ratings of its debt to default status, but after a long gap. The payment of interest was due on February 7, 2017, but was made on April 10, 2017. Rating agencies, however, downgraded its debt instruments only by the end of May, amounting to a delay of over two months. “Any time there is a delay in payment or a default happens, credit rating agencies are supposed to get real-time information and it should reflect immediately in their ratings,” says Manoj Nagpal, chief executive officer, Outlook Asia Capital. 

In 2015, Amtek Auto’s bonds saw a sharp downgrade, which precipitated a redemption crisis in two debt funds belonging to JP Morgan Asset Management. In these cases, say experts, CRAs did not take into account the deteriorating financial condition of these companies to downgrade their ratings at regular intervals. “In the normal course, downgrades should happen one notch at the time. They should not go from, say, double-A to default at one go,” says Mumbai-based financial planner Arnav Pandya.

What Sebi wants: Sebi’s recent circular says that CRAs need to be proactive and detect early any default or delays in payments by issuers. CRAs should look for potential deterioration in financials that could lead to delay or default, particularly before or around the due date for servicing debt obligations. The circular mentions several indicators that CRAs should monitor: EBITDA not sufficient to meet interest payments for last three years; deterioration in issuer’s liquidity condition and abnormal increase in borrowing cost. 

In case a CRA doesn’t receive confirmation from the debenture trustee (appointed to protect investors’ interests in case of a listed debt instrument) regarding servicing of the debt obligation within a day after the due date, the CRA should follow up with the issuer for confirmation of payment. In case a confirmation is not received within two days, it should issue a press release and also inform Sebi. 

The circular also speaks of several material events after which the CRA must review the issuer’s rating. The CRA should publish the change in rating (or the same rating, as warranted) within seven days of the event. To ensure timely recognition of default, CRAs will now have to obtain a no-default statement (NDS) from the issuer, latest by the first working day of next month. The NDS should explicitly confirm that the issuer has not delayed payment of principal or interest in the previous month. In case there has been a delay, this should be stated. In that case, the CRA should conduct a review of the ratings and disseminate it within two days. “Earlier, CARE used to ask for a quarterly statement from companies. Now we will start asking for monthly statements, so we will have information on any delay or non-payment faster,” says T N Arun Kumar, executive director, CARE Ratings. 

The flow of information to CRAs is likely to improve. “Sebi’s circular makes it obligatory for issuers and debenture trustees to share information with CRAs in a time-bound manner about whether payments have been made,” says Anjan Ghosh, chief rating officer, ICRA. 

What can debt investors do: While the reforms that Sebi is trying to bring about should have a positive impact, investors in fixed-income instruments need to remain vigilant. They should be wary of the growing credit-related risk in debt mutual funds. Credit exposure of debt funds is growing rapidly. The credit opportunities category has doubled in size within the past year. The credit accrual category is often sold to investors on the basis of the yield-to-maturity (YTM) it offers. To maximise YTM in a falling interest rate scenario, fund managers are taking exposure to lower-rated debt instruments, despite the absence of adequate liquidity. Investors should exercise caution. Says Suyash Choudhary, head-fixed income, IDFC Mutual Fund: “If historically you have been a bank deposit customer and are entering debt mutual funds, what you are really coming for is steady income. Take limited duration or credit risk in the bulk of your portfolio. The major part of your debt fund portfolio should be invested in conservatively run short-term and medium-term products.” About 70-80 per cent of investments should be in funds that invest in triple-A and double-A+ papers. For the last 20-30 per cent of your portfolio, you may take some exposure to duration or credit-oriented funds. 

Nagpal says when investing in debt mutual funds, go for fund houses that have a strong internal rating process, apart from just following the ratings given by CRAs. 

Pandya says risk in debt mutual fund portfolios emanates from paper that is highly rated but doesn’t deserve it. “Suppose there is exposure to companies whose financials are not in good shape, or whose share prices are falling as they are facing problems. If exposure to such papers is high, withdraw your money and invest elsewhere,” he adds.  If you are investing directly in bonds or company fixed deposits, 80-85 per cent of your investment should be in triple-A paper. Don’t keep more than 20 per cent in double-A+ paper and don’t go lower than that grade.