Transparency needed in rating hybrid bonds

ANALYST'S VIEW

Rating innovative perpetual (tier-I) debt instruments and upper tier-II debt instruments poses an interesting predicament.

While the credit risk on these instruments remains strongly linked that of the issuer, the instruments are certainly different from senior or more conventional subordinated debt.

Apart from 'interest deferral clause' their loss absorption capacity is different i.e. higher. Simply put, these instruments represent more junior claims on the funds flow and assets of the issuing entity relative to those of senior and conventional subordinated debt.

There seems to be a difference of opinion among rating agencies on whether hybrid debt instruments should be rated at same level as senior debt instruments. The big question is whether to 'notch' the ratings of these instruments or not.

Notching down the rating of a debt instrument from the Long-term (issuer) or senior debt rating of the bank to reflect the instrument's relatively higher risk characteristic is a common practice internationally.

Whereas the probability of interest deferral in case of higher-rated credits with stronger ability to maintain capital ratios above the regulatory minimum is low, an 'AAA' rated bank issuing an 'AA+' rated paper is not unusual in developed economies.

What could be unusual is to find different classes of debt instruments with distinct risk profiles issued by an issuer rated at same level. 'Equity-like' characteristics in hybrid instruments (in some instances interest may be non-cumulative in conjunction with being deferrable) make it impossible to equate them with senior debt instruments.

Regulators treat these instruments differently while calculating a bank's capital adequacy ratio and so do investors who demand a higher return to compensate for higher risks inherent in these instruments.

The national rating of hybrid instruments issued by Indian banks need to follow a similar logic. Like other central banks, the Reserve of Bank of India too treats hybrid debt preferentially, while computing capital adequacy ratio and investors behave no differently here "� Indian bank's hybrid issuances command a higher risk premium.

This implies that there is a need to notch hybrid debt ratings. Selective notching or notching only in exceptional circumstances would represent that in majority of cases risks of investing in senior debt instruments are similar to that of investing in hybrids and creates confusion in the minds of investors.

A transparent rating methodology that clearly enumerates the risk inherent in such instruments is the ideal way to communicate to potential investors. This seems to be the regulator's expectation, and this is what Fitch practices, both in the national and international markets.

The author is a senior director and chief operating officer at Fitch Ratings.