Understanding Credit Ratings

All investment instruments carry risk. Bonds, too, carry many different kinds of risks - and every investor must make themselves aware of these risks before committing their hard earned funds to them. For instance, bond prices fluctuate depending upon broader interest rate changes effected by the central bank of any country (in our case, the RBI).

However, if you plan to buy and hold a bond until maturity (like most retail investors do), the fluctuations in its price over the course of your holding period will make little difference - it is only when you plan to sell any item, does its price volatility bear any significance.

In such a scenario, what matters is the creditworthiness of the company whose bonds you are purchasing, since you are in essence lending money to the company. This is where credit ratings come in handy. Very few individual investors will have the time or resources to dedicate towards a thorough exercise of evaluating the chances of a corporate default, so fortunately, we have credit rating agencies such as CRISIL, ICRA and CARE who perform this exercise.

The basics of the Rating Process
It may come as a surprise to you that most credit rating agencies globally follow a model where the issuer pays for the rating exercise. While this, in principle, may create conflicts of interest, such instances are actually a rarity. During a rating exercise, issuers provide the rating agency with confidential information which the general public isn't privy to. Generally, rating agencies do not provide a rating unless an adequate disclosure is made. Interactions with the company are a must.

Having completed the evaluation process, the agency comes to definitive conclusions about the company's ability to service its debt obligations, and assigns it a rating ranging from AAA (very high quality debt, invest without a shadow of doubt) to D (expected to default soon, do not touch with a barge pole!). The various ratings in between the two ends of the spectrum are AA,A,BBB,BB,B AND C respectively.

"All the ratings are assigned by a rating committee, comprising members with professional expertise. The committee-based approach entails assessment by a group of experienced professionals, thereby ensuring objectivity of the rating", says Somasekhar Vemuri, Senior Director, CRISIL Ratings.

A credit rating doesn't guarantee or assure repayment, but can best be defined as a probabilistic estimate of default. "A credit rating is an opinion on the relative degree of risk associated with repayment of the rated instrument, and not an assurance of repayment", emphasizes Vemuri.

The various ratings
As mentioned earlier, AAA rated bonds are considered to have the highest possible degree of safety. Surprisingly, India leads the Global back in terms of AAA rated companies, with over 70 (compared to 14 in China). HDFC, Dewan Housing and Bank of Baroda are examples of companies that have their domestic long term debt rated as AAA. Most PSU issues (such as Rural Electrification Corp) are AAA rated.

Instruments with a AA rating are also considered to have a high degree of safety with respect to timely servicing of their debt obligations. The recently issued bonds by Edelweiss Housing Finance were rated as AA by CARE. Bonds that are rated A can be said to have an adequate degree of safety.

A bond that carries a rating of BBB may still be considered fairly safe, but those that are rated BB or B should be approached with caution, as they carry moderate to high risks of default. Examples of bonds currently rated B by CARE include smaller enterprises such as Appu Hotels, Carthic Credits & Trancity Finance & Leasing. You need a lot of courage and optimism to buy these bonds!

Bonds that are rated C or D have a very high risk of default, or are already in default. Companies such as Era Infra & Gammon India were rated D by CARE in their recent June 2016 report.

"Usually instruments that have lower credit rating have higher coupon rates or yields. Such instruments, therefore may be more aligned for institutional or informed investors with a higher risk appetite. Globally, there is an active market for lower rated bonds usually termed 'junk bond market'", informs Vemuri of CRISIL Ratings.

In Conclusion
Retail Investors are always advised to check for credit rating before buying a bond. Unfortunately, lower rating bonds offer higher commissions to intermediaries that sell them, and this creates a conflict of interest between investors and distributors. Many companies which carry strong brands may in fact be struggling with impending defaults - a case in point is Jaiprakash Associates, which was part of the NIFTY composition until 2014, but whose bonds are now rated D by CARE.

Irrespective of the returns on offer, you'll be making a wise move by sticking to AAA, AA or A rated bonds. "High credit ratings have higher safety levels", says Vemuri in conclusion.