Bond with the best

If stock market investors should stay away from companies with high debt, those investing in fixed deposits or bonds had better pay close attention to the company’s credit ratings. With the spectre of defaults on the rise, this is not the time to seek high returns from debt instruments, as this could come with disproportionately high risks.

For one, deteriorating financials are prompting the credit rating agencies - CRISIL and ICRA - to steadily reduce the ratings on the bonds under their watch. The percentage of entities rated BB (considered to have moderate risk of default) or lower by ICRA, increased from 23 per cent as on March 2009 to 75 per cent as on March 2013. The ratio of downgrades to upgrades was at 2.6 last year.

Sectors which witnessed a high number of defaults include realty, construction, textiles, engineering, metals and mining.

After the sharp correction in gold prices, for instance, ICRA had downgraded ratings on gold loan companies, Muthoot Finance and Manappuram Finance from ‘stable’ to ‘negative’. This was on account of expectations of rise in delinquencies.

CRISIL has a similar story to relate, with downgrades outnumbering upgrades by 60 per cent. The main reasons for defaults in 2012-13 were stretched liquidity arising out of increased receivables or inventory, demand slowdown and delays in project implementation.

Stick to AAA

However, even the above picture may not reflect the recent liquidity problems at India Inc, given that short term borrowing costs have spiked only after RBI measures in July. As lower rated companies are more likely to face stress, it is best that investors stick to AAA rated instruments for now, as these have shown more stability in ratings.

Gruh Finance, HDFC, LIC Housing Finance and Mahindra & Mahindra Financial Services are all AAA rated. As capital protection is critical for depositors it is best to stay with companies with good track record.

Not even AA

Lower rated instruments do not offer a sufficient premium for risk, as things stand. Consider these numbers. During the financial crisis of 2008-09, AA bonds offered nearly 2 percentage points more interest than top quality bonds. But today, though the economic environment is far worse, the difference in yields is only 50 basis points. Thus, the investor in lower rated bonds is hardly compensated for the risk he takes on.

In this genre, PNB Housing Finance for instance, offers 9.3 per cent for a fixed deposit that is AA-rated. The company is a relatively smaller player in the housing finance industry . Shriram Transport Finance is also rated AA, and offers a better interest rate of 10.75 per cent. While the company has a strong market presence in the commercial vehicle financing, rising delinquencies in this segment may be a concern. Comparing with AAA rated fixed deposits, the difference in interest rates may at best be 100 basis points.

Keeping in mind increasing risk of default, insufficient yield differential and low liquidity on lower rated debt instruments, investors should look stick with high rated issuers even if they offer lower interest rates.

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