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KEY TAKEAWAYS

1. Credit rating agencies in India, such as CRISIL, ICRA, CARE, and India Ratings, assess the creditworthiness of bond issuers, helping investors gauge the likelihood of default.

2. Credit ratings provide insights into a bond issuer's financial health but are not recommendations to buy, sell, or hold bonds. They should be part of a broader investment strategy.

3. Various risks, including interest rate, liquidity, inflation, and reinvestment risks, affect bond investments, and investors should be aware of these alongside credit ratings.

4. Credit rating agencies are regulated by SEBI, but their assessments are independent and not infallible, as past incidents have shown they can overlook critical financial issues.

5. Investors are encouraged to conduct their own research and not rely solely on credit ratings to make informed investment decisions and protect their investments.

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I am sure most of us have used Zomato or Swiggy to order food, right? Before placing the order, we definitely focus on the restaurant's rating because it is an overall measure of the restaurant's service, including hygiene, quantity of food, delivery experience, ambiance, and customer service. The higher the rating (out of 5), such as 4.2 or 4.7, the greater the chances of the restaurant’s overall food and service being good.

But it's noteworthy that the rating cannot be seen as a ‘guarantee’ of the food or service always being great for a restaurant. A restaurant with a high rating may sometimes disappoint you, whereas, on the other hand, a restaurant with an ‘average’ rating of maybe 3.5 can turn out to be good sometimes!

And just like that, a similar mechanism of ratings is available for bonds. Given that the biggest risk when investing in a company's bond is its possibility of default, checking the bond issuer's credit rating can indeed be helpful to lower your risk of losing your hard-earned money, as a higher credit rating signifies that the bond issuer is likely to repay its debt obligations timely.

But what exactly are credit ratings? Who assigns those ratings? And how do the rating agencies assess and calculate the credit ratings for every bond issuer? That is exactly what we will simplify for you, in this blog of ours.

What is a credit rating agency?

A credit rating agency is an entity which assesses the ability and willingness of the issuer company to timely pay the interest and principal on the debt instrument it is issuing, such as corporate bonds. Some of the leading credit rating agencies in India include CRISIL, ICRA, CARE and India Ratings.

What does credit rating convey?

Remember how we talked about a restaurant’s rating on Zomato and Swiggy? It acts as an overall measure of the restaurant’s service, be it the food, hygiene, delivery, ambience, etc.

Similarly, a bond issuer’s credit rating acts as an assessment of the probability of default on payment of interest and principal on a debt instrument, like the bond it issued. Credit ratings are in no way a recommendation or suggestion to buy, sell or hold a bond. Ratings should only be treated as a credit rating agency’s assessment of the bond issuer’s financial health and credit repayment capacity.

Generally, higher the credit rating of the issuer, lower are the chances of defaulting on its debt repayments. But, it’s noteworthy that credit risk (risk of default) is not the only risk which exists for investors. Besides credit risk, some other risks that affect a bond investment, which investors should keep in mind, include:

• Interest Rate Risk: If interest rates rise, the value of existing bonds tends to fall. This is especially important if you're planning to sell the bonds before maturity.

• Liquidity Risk: Some corporate bonds may be hard to sell quickly, especially those issued by smaller companies or in illiquid markets.

• Inflation Risk: If inflation rises significantly, the real value of your fixed coupon payments can decrease, reducing the purchasing power of your bond income.

• Reinvestment Risk: Reinvestment risk is the probability that an investor will not be able to reinvest cash flows, such as coupon payments, at a rate equal to their current return. Such risk can arise in case your bonds contain a clause that allows the issuer to redeem before the due date/maturity, i.e. do a prepayment. This can force investors to reinvest at the current market interest rates, which usually tend to lower than the ones at which you had earlier invested.

What parameters are factored in when assigning an issuer’s credit rating?

Credit rating agencies conduct a comprehensive evaluation of a company’s strengths and weaknesses, in terms of its financial fundamentals, as well as the industry analysis, macro-economic, regulatory and political environment.

Different credit rating agencies factor in a different set of parameters while assigning a rating to an issuer. Nonetheless, some of the common factors that may be taken into consideration for credit rating by the agencies, are:

1. Operational efficiency

2. Level of technological development

3. Competence and effectiveness of management

4. Past record of debt repayment

5. Competitive position in the industry

6. Management quality

7. Funding policies

8. Estimates of future earnings

To give you more clarity, here’s a snapshot of the credit rating process of CRISIL:

Who regulates the credit rating agencies in India?

Yes, the credit rating agencies in India are regulated by SEBI. The SEBI (Credit Rating Agencies) Regulations, 1999 govern the credit rating agencies in India and oversee regulations and guidelines regarding the eligibility criteria for registration of an agency, monitoring and review of ratings, avoidance of conflict of interest, time to time inspection of rating agencies , etc.

But one thing that you all should be aware of is that while market regulator SEBI oversees the agencies, it does not have any role in the rating assessment done by the agencies. Ratings are meant to be an independent, professional and unbiased opinion of the rating agency.

Also, the credit rating process is not a one-time task. Credit rating agencies need to regularly and continuously monitor the rating of issuers and securities and also carry out periodic reviews of the published ratings, which is exactly why you often hear or read that an issuer’s rating has been upgraded or downgraded, whenever the agencies assess a change in expected performance of the issuer regarding the future repayment abilities.

Are credit rating agencies always right?

Mostly yes, but sometimes no. While credit rating agencies are fairly accurate when evaluating a bond issuer’s financials, they have not been 100% right every time, and have made a few mistakes in the past, though it's still a rare thing to happen.

For instance, do you remember the downfall of IL&FS? The company had first defaulted on their Commercial Paper (CP) repayment in June 2018, even though they still held a AAA rating as late as August of that year. Back in 2015, the RBI had already flagged issues with IL&FS. By 2017, it was clear there were significant problems, like a lack of liquidity in bond markets and a huge mismatch in assets and liabilities. Despite these warning signs, the credit rating agencies overlooked the company’s cash flows and balance sheet issues and continued to give it the highest rating.

When the situation worsened, the CRAs quickly downgraded the ratings from AAA to D and even stopped covering them. This kind of drastic change is almost typical in the industry and has been seen repeatedly. Similar patterns occurred with major defaults in the past, like with Bata and tractor company Escorts in the 90s, and more recently with Ricoh India, Amtek Auto, and DHFL.

This goes to show that while credit rating agencies usually give us a decent overview of the financial products we're considering, they shouldn't be relied on without question. They depend on two main factors: funding from the issuers they rate and the financial data those issuers provide. This can sometimes lead to less accurate ratings.

Therefore, it's wise not to blindly believe these credit ratings and always do some homework of your own too, after all, it's your hard-earned money that you are investing!

How can an investor evaluate the risk in an alternative investment?

You can check out this detailed video by ALT Investor’s founder Yash Roongta, as he explains how investors can evaluate the risk before investing in any company’s bonds.

If you prefer to read a blog instead of watching a video, we have a detailed article on this as well, wherein we have mentioned a checklist for investors to assess risk in fixed income products: https://blog.thealtinvestor.in/the-good-old-marriage-of-risk-and-returns

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Conclusion

In conclusion, we can all agree that credit rating agencies play a crucial role in India's bond market, given that they provide investors with an assessment of the creditworthiness of bond issuers. While these ratings offer valuable insights into the likelihood of default, they are not infallible and should be considered as one part of a broader investment strategy. Investors should be aware of the various risks associated with bond investments, such as interest rate, liquidity, inflation, and reinvestment risks.

Additionally, it's important for investors to conduct their own due diligence and not rely solely on credit ratings, as past incidents have shown that agencies can sometimes overlook critical financial issues. By combining credit ratings with personal research and risk assessment, investors can make more informed decisions and better protect their investments.

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Please note that this is an opinion blog and not an official research or investment advice This blog aims to help retail investors make an informed decision in the debt market, and neither encourages nor discourages you from investing in any particular platform or any other asset class.

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