All you wanted to know about downgrades

The recent downgrade of IDBI Bank’s debt obligations by rating agency ICRA made headlines. ICRA’s action follows downgrades of the bank’s debt by other rating agencies such as CRISIL and Moody’s over the past month.

A credit downgrade by a rating agency shows its confidence level in the company’s debt repayment ability has waned. A credit rating reflects the rating agency’s opinion on the likelihood of timely payment of interest and principal on the debt obligation.

For instance, ICRA downgraded IDBI Bank’s Basel-III compliant Tier-II bonds from AA- (high degree of safety regarding timely servicing of financial obligations) to A @ (adequate degree of safety; put on rating watch). Additional Tier-I bonds have been downgraded from A- to BBB@ (moderate degree of safety and hence moderate credit risk). The bank’s fixed deposit programme which was rated MAA- has also been put under rating watch.

Downgrades can offer insights into the underlying financial performance of the company. For instance, the downgrade of IDBI Bank takes into account the bank’s weak operating and financial performance during FY17. Weak capital position and continued stress on profitability and asset quality have been cited as concerns. Downgrades and their reasons matter to various stakeholders including bond holders, stock investors and bank depositors. They serve as red flags and could be a call to action.

If you have invested in bonds, then the company’s reduced capacity to meet its payment obligation, reflected in a downgrade, is a concern. Retail investors have exposure to such bonds mostly through debt funds that invest in these bonds.

The NAV of debt funds moves with underlying bond prices. Among other factors including interest rate movements, bond prices reflect the ability of the company to service its interest and principal. If a company actually defaults on its interest or principal repayment, then the debt fund’s portfolio, to that extent, is written off. This will impact the NAV of the debt fund.

Even if a company does not default, rating agencies can downgrade the rating on these bonds for several reasons. This can also mark down the fund’s NAV. As mandated by the SEBI/AMFI, while calculating NAV, mutual funds follow a valuation matrix prescribed by rating agencies for valuing illiquid corporate debt papers. This matrix considers factors such as credit risk, interest risk and liquidity risk, based on which illiquid corporate debt papers are valued and marked-to-market. A rating downgrade could lead to lowering of valuation.

Downgrades also have implications for investors in the stock of company. Over the past month, the stock price of IDBI Bank has plummeted 21 per cent. Bank depositors too could be affected indirectly. Rise in bad loans can erode banks’ profits and capital.

Capital helps banks absorb losses in the normal course of operations. So, if a bank has a weak capital base, then in case of a loss on account of defaults by its borrowers, it may not be able to honour demands from depositors. In India, instances of commercial banks going kaput are rare, thanks to the backing of the Centre. Also, deposits are insured. Still, depositors need to be watchful.

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