Why ratings matter to you, as a debt investor

The downgrade of US sovereign debt from AAA to AA+ by credit rating agency Standard & Poor triggered global market turmoil. Countries such as China that hold high exposure to US treasury and bonds bristled and demanded a new reserve currency. Well, unless you are an equity investor and witnessed your stocks being pummelled, this may have been just another news event for you. That may be so, but did you know that credit rating, at a more micro - corporate level - could have a bearing especially on your own debt investments?

A credit rating on your debt instruments can offer some clues as to whether you would be regularly paid the interest and get back your capital safely. Credit rating bequeathed on instruments such as fixed deposits and non-convertible debentures have become more important than ever in the current rising interest rate scenario. Read on to know what credit ratings tell you about the safety levels of your investment.

Interest rate lure

Attractive interest rates of 11-12 per cent offered by various debt avenues have been a big lure for investors in recent times. Investors also appear to be flocking to these debt avenues to escape the volatility in the stock markets. The NCDs of high investment grade companies such as Shriram Transport Finance Corporation as well as the next rung of companies (in terms of risk) such as India Infoline Investment Services (IIISL) received a thumping response; being fully-subscribed well ahead of the closing date.

However, it is important not to merely go by the coupon/interest rate when it comes to investing in these instruments. Investors need to be aware of the ability of the issuers of such instrument to meet their financial obligations, as promised by them. To gauge this, it may help to conduct a check on the financial numbers of the issuer as well as the credit rating issued by the rating agency for the specific debt instrument.

If you feel less equipped to do an analysis, you can look out for the opinion of rating agencies such as Crisil, Care, Fitch or ICRA on the credit risk of these companies. For instance, Shriram Transport Finance's NCD offer in June 2011 came with a Crisil AA rating implying a “high degree of safety regarding timely servicing of financial obligations (interest pay outs) and very low credit risk”.

In the case of Crisil the highest rating awarded for long term instruments is AAA and the lowest is D (default or risk of default). For retail investors, any long term instrument below AA can be considered risky for retail investors. A BBB rated instrument for instance is defined as carrying ‘moderate credit risk' by the rating agency, but in reality could hold very high risks as many instruments in this category can easily slip in to default grade.

As retail investors typically opt for debt options to mitigate the risk profile of their portfolio, it may not be prudent to take high risk in debt for the sake of returns; more so if the investors are senior citizens or retirees with little other sources of income.

Some instruments may carry very marginal differences in rating. For instance, the recent IIISL NCD issue had an AA- rating from rating agency Care as against the current Shriram City Union Finance NCD offer which has a higher AA rating. The suffix + or – indicates comparative position of the instrument as a result of minute differences in risks; IIISL rating implying higher risk in this instance.

Risk premium

How do companies attract funds when their risks are higher? A higher return is their solution. While credit rating is an important factor for an investor to know the risks being assumed, it is noteworthy that the rating is not investment advice by itself.

A high rating on the debt instrument of a commodity company for instance, may not factor any cyclical downturn in the business. The rating may also not warn you of any sudden liquidity crunch that a company may face. Hence, investors would have to dig some primary information about the company too. This is more important in the case of fixed deposits, as NCDs at least offer an exit option in the market as they are traded.

While NCDs do come with a credit rating, fixed deposits of corporates barring NBFCs quite often do not get a rating on their deposit schemes. Investors have a couple of options to decipher the risks in these cases. One is the elaborate way of checking its profit and loss and balance sheet which is often disclosed in the application form or can be checked with your agent/investment advisor.

The other is to demand for the long-term debt rating that the company may have recently received for instruments other than deposits or check for the same in the internet. This would still provide an indication of what to expect from the issuer. Three, and a simple thumb rule is to stay away if the company provides 3 percentage points (or more) higher than a triple A or double A rated NBFC deposit such as HDFC or Sundaram Finance.

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