(From an old Moneylife issue)
Understanding Credit Ratings
06 September 2016 0
Credit rating is a much-misunderstood concept. It is also a much-abused concept. Normally, not many people care to know about rating. It’s only when ratings suddenly go wrong and there are defaults and downgrades, that there is a lot of outrage and the regulators and the public react sharply. The recent debacles of irresponsible investors have put the focus on credit rating. It is important that we understand the limitations of credit rating.
The first thing to understand is that ‘rating’ is an opinion. It expresses, in symbols, the likelihood of default in a specific debt instrument to which the rating applies. It is NOT a view on the company. For example, we may perceive Infosys/ITC/Tata Steel, etc, as ‘Triple A’ companies. This is where we make our first mistake. A credit rating applies only to a specific debt paper. It is possible that the same company may have two debt papers with separate ratings if the features are different. And a credit rating of a specific debt cannot be taken as a proxy for more lending. Often, our perceptions are clouded by the promoters, the share price performance and the fact that a company is debt-free, etc. A high credit rating is generally a good indicator of a good company, but it is not the sole guarantee. It is only a ‘confirmatory’ factor.
A credit rating agency uses several assumptions and these are all forward-looking views. Thus, there could be a change in the credit rating, should some events not materialise as expected. And industry dynamics keep changing. A rating agency will try to take a middle-of-the-road approach; it cannot take the most optimistic or the most pessimistic view.
We have to use credit rating as the first guide to preparing a shortlist for investing in debt instruments. Especially, if the investor is a ‘professional’ one—like a mutual fund or a pension fund. In today’s world, every investor does not know everything about every company. Credit rating merely helps a professional investor to prepare a shortlist and also to price the instrument. It is only the first step before an investor can take a final call to invest or not. The due diligence, in terms of homework, legal documentation and pricing, etc, is the work that the investor has to do. He cannot take the credit rating as the only requirement.
Research houses place ‘buy’ recommendations on equity shares. Do we ever hold them accountable or liable if the share price does not behave as expected? Credit rating is in the same category. Ultimately, the credibility of a rating agency is built over time. Agencies, like Moody’s and Standard & Poor’s, have been around for over a hundred years. If you take the total number of ratings assigned by them and take the number of errors, it would not be a large percentage. In the meanwhile, a few rating agencies came and went. It is still a duopoly in the developed world. Other agencies are ‘also-ran’ and carry less credibility than the big two.
In India, our approach to credit rating has been wrong. First of all, rating agencies are regulated by an agency that has no skills to regulate them. Secondly, we introduced the concept of ‘recognition’—that means that we let the door open to let in as many as possible. And we also let lenders control a rating agency (of course, with the so-called ‘Chinese walls’) and the result is not so good. Firstly, the lending agency ‘passes’ business to its subsidiary by coercion. And, when there are half a dozen ‘recognised’ rating agencies, there are bound to be one or two that will take the shortcut to get market share. ‘Shopping’ for ratings has become common now. And, in India, credibility is not as important as ‘managing’ the environment.
In the marketplace, most serious investors in debt do make a distinction between the rating agencies. They do not admit it publicly; but if you go through the history of rating disasters (I still maintain that if we look at the total history of credit rating in India, by and large, it has been a fantastic job).
The one disaster India has escaped has been the ‘exuberance’ of the rating agencies when it comes to ‘structured’ finance. The Lehman Brothers’ disaster was a defining moment in the history of credit rating. Liberal ratings, poor structures and the subsequent setback to the financial system, made the pre-2008 period in the US one of the worst periods in the history of credit rating. Rating agencies fought with each other to come out with more and more exotic structures on ‘demand’ by investment bankers who just wanted to collect fat fees for raising money and parking it with professional investors who used credit rating as the excuse, or justification, for their investment. It was a fraud on the financial system where everyone was guilty. And the prime focus was on the rating agencies, since they were the ‘holiest’ of the entire group of participants.
For retail investors, credit rating is of no practical use. The only place where they come in touch with rating is in the fixed deposit or retail bond markets. Here, I would urge people to remember that a rating agency is merely giving its opinion which can change anytime. It is based on assumptions of business, industry and probability of outcomes. The rating symbol is only a starting point. If you cannot do any analysis, it is better to put your money in a mutual fund that invests in debt instruments. Or if your amounts are small, then do not risk an extra percent or two; play safe and stick to bank deposits. We also have ourselves to blame. I know of people who lost money in fixed deposits. In most cases, the papers were either without a credit rating or a low rating. And there is also a pattern to the defaults in the local debt market. You have to make a distinction between the rating agencies. Personally, if there is a company where I have to depend on the credit rating alone, I will let that investment pass.
A credit rating, for a professional investor, is only a tool to shortlist or a starting point. He has to do his due diligence, analyse all the pros and cons and then take a decision. Often, in the institutional segment, the call to invest is taken by the fund manager at a very short notice. A credit decision is more complex than an equity investment decision. Investing in credit is actually taking a call on a company’s ability to pay interest and repay principal on the precise due dates. Analysis of the cash flow matters a lot. The legal system is complex. And, unlike equity, which can be sold at some price or the other, debt is either repaid in full or you get zero on the due date. Getting money after the due date may be OK for a banker, but not for a mutual fund or the individual investor. To sum up:
1. Credit rating is just an opinion, like a broker’s report on a share;
2. Investor has to do his due diligence before taking the call;
3. Rating agencies build reputations/trust on the basis of their track records;
4. Merely being a ‘recognised’ rating agency does not mean anything. Pedigree, process and reputation matter;
5. Credit ratings are specific to debt instruments. We cannot use them as a proxy for other papers or debt;
6. There is no such thing as a ‘company’ rating;
7. Depending solely on a credit rating for any investment or lending decision is irresponsible financial behaviour;
8. No amount of regulatory supervision will guarantee the integrity, or otherwise, of a credit rating agency. Reputation gets built over time.