Ratings alone shouldn't be used for investment decisions

Sebi's recent circular plugs many loopholes but some lacunae remain

In less than a decade, the Securities and Exchange Board of India (Sebi) has completely changed its position on the importance of credit rating for both equity and debt instruments.

In 2007, Sebi had made grading of initial public offerings (IPOs) mandatory. Six years later, in 2013, it made it voluntary. During the past year, it has mandated that fund houses do their own research when investing in debt papers. Ratings from credit rating agencies can only be used as secondary support — a move many chief executive officers (CEOs) of fund houses have applauded. Says the CEO of a leading fund house: “Since we are in the business of making investment decisions, research is the backbone of that. And, if a fund house does not have capability to do so, it should get out of that product line completely.”

What led to these decisions? According to Sebi’s observations, IPO grading had not served the intended purpose as investors, both retail and qualified institutional buyers, were not using it. “This indicates grading has not been a factor in investors’ decision-making process,” said Sebi. 

In the case of debt companies, in February 2015, the credit rating of Jindal Steel and Power’s bonds was downgraded, which hit fund houses like Franklin Templeton that had invested in it. In August that year, Amtek Auto’s bonds saw a sharp downgrade, which precipitated a redemption crisis in two debt funds belonging to JPMorgan Asset Management. 

These events culminated in Sebi’s November 1 circular that aims to enhance standards for credit 

rating agencies.

Enhancing transparency: All ratings have to be disclosed compulsorily. Till now, the practice was that a rating was made public only if the issuer accepted it. “The investor will now know the ratings assigned by different agencies. Also, jumping from one rating agency to another may no longer serve the purpose and this will enhance transparency,” says Vivek Mathur, executive vice-president and head-rating operations, ICRA.

The circular says if a company goes from one rating agency to another, the second agency will have to disclose why the issuer did not co-operate with the earlier one.

Another important provision in Sebi’s circular pertains to review of ratings. A rating is a forward-looking measure: It is assigned on the basis of the rating agency’s analysis of what will happen in the next 12-18 months. The agency, now needs to keep a watch on whether the hypothesis is coming true. If there is a deterioration in outlook, the rating should be downgraded. If it remains the same, it should be reaffirmed, and if things pan out better than anticipated, the rating should be upgraded. If the rating agency is unable to come out with a review at the right time, it needs to state the reasons for its failure to do so.

Sebi has allowed rating agencies to mention, alongside the rating, that the issuer did not cooperate and the rating is based on the best available information. Since companies usually stop providing information when things are going badly for them, investors can use this as a signal and take appropriate decisions.

Another practice Sebi wants to stop is the sudden suspension of ratings. Till now, when a company’s financial performance deteriorated, it would stop cooperating with the rating agency. The rating agency would then suspend the rating. “Investors who had put money in that company’s debt instrument were left high and dry because of lack of information,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. The new guidelines state that once started, the credit rating agency has to continue rating the instrument over its tenure. 

Lacunae that remain: The biggest conflict of interest within the rating process arises from the fact that the entity getting rated pays for it. “Rating agencies very well know that if they give the borrower a bad rating, they will lose business,” says Mumbai-based financial planner Arnav Pandya. 

Ratings can be completely fair only if the user of the rating pays for it. A common fund, say, along the lines of the investor protection fund, could be created to pay for ratings. However, investors who don’t use ratings would then complain about being unfairly charged for something they don’t need. And when the rating is called for by a third party, the issuer company may not allow the rating agency access to its books. Credit rating changes, many times, fall behind the curve. “If the credit rating changes only when everyone, or at least all the savvy investors, already know that a company’s paper is junk, then ratings hardly serve their purpose of being a lead indicator,” says Manoj Nagpal, chief executive officer, Outlook Asia Capital. 

Rating agencies also at times drop ratings by three-four notches at one go — a problem that Pawan Agrawal, chief analytical officer, CRISIL Ratings, believes the Sebi circular may help address. “Rating outlooks have been made mandatory, which reduces the possibility of sudden and sharp rating changes. Outlooks enable investors to anticipate the direction of rating changes over the near-to-medium term,” he says.  

What should you do? Given the lacunae discussed above, investors should not rely on ratings alone. They should keep a close eye on the financial performance of the company, whose debt paper they have invested in, and also track news and developments about it in the media. They should also enquire periodically from end-users about the company’s products and services. “If you hear too many customers complaining, you should be wary of lending money to such a company,” says Pandya. More savvy investors may even check with suppliers. “In case of financial distress, payments are the first to be affected,” says Nagpal.