Credit rating illusion and the myth of safety in debt investing

The popular perception is that investment instruments in the form of debt or fixed income, such as, fixed deposits, bonds, debentures (NCDs), debt mutual funds etc. are safe. Whatever instrument has some form a coupon rate specified on its label is deemed safe, while any instrument which doesn’t specify a coupon on the label is deemed risky.

 

Typically, there is an “independent” rating given to these debt instruments by credit rating agencies and this further reinforces the “safety” feature of these instruments in the investors mind giving them “moral comfort”. Whether this “moral comfort” has any basis is a completely different matter. Further, this perception of safety and confusing a specific coupon and rating on the label is not just restricted to retail investors. The High Net Worth Individuals and the highly educated and financially sophisticated financial advisors, wealth managers and investment officers of institutions are equally prone to fall into this trap.

 

The recent episode triggered by the ILFS defaults which had a direct impact on the debt mutual funds and then other NBFCs and then their stocks and then the overall equity market is a symptom of this belief in a flawed concept.

 

On a very superficial and theoretical level, debt instruments having priority over equity in a company’s liquidation rights makes them relatively safer as compared to equity in that company. However, with all that focus on relative safety and the coupon rates and the credit ratings, distracts the investors and advisors—in a manner like that used by magicians—from the fundamental focus on whether the company itself is safe in the first place.

 

On top of that the fundamental flaw of ratings is that the credit rating agency is appointed and paid for by the management of the company which needs to be rated. It is slightly analogous to a student appointing their own choice of teachers to test and grade them and being the one who pays the teachers.

 

 

Economic incentives will probably have some influence on the credit rating agencies’ view of how to rate the company and its instruments.

 

Further, the illusion of an “independent” rating by a third party and its sheer availability makes the investor or the fund manager of a debt fund feel slightly less anxious and sceptical when choosing a debt instrument. If there were no ratings and the investor or fund manager had to completely rely on his or her own analysis, they would probably go to greater depths of analysis before investing.

 

All of this brings the point home that the ratings are an illusion and one needs to do their own analysis, completely ignoring the ratings provided. However, if there is a written narrative with the rating, that can be paid more attention to. The most important part of the analysis would be to study the business, the balance sheet, the income statements and the cash flows over several years under different circumstances and stages of economic cycle.

 

Further, understanding the business and the key risk factors in the value chain need to be understood. Are the clients doing well? Are the suppliers doing well? Are the competitors doing well? Who has the bargaining power in the value chain? What about the regulatory risks? What about internal risk of labour, management, non-labour personnel and operations?

 

All of this should be showing up on the quarterly and annual financial reports. However, sometimes it could require access to closer scrutiny of the company’s operations which, supposedly, the rating agencies have.

 

However, the recent defaults and the fact that debt mutual funds and even the liquid mutual funds were holding this paper, demonstrates that the illusion works in the market and fund managers do have blinkers on many times.

 

The even more alarming fact is that the liquid mutual funds are not supposed to carry any risk, not even interest rate risk and hence should ideally have been completely or more than 75%-80% in t-bills. However, despite the public disclosures of the holdings of these liquid funds and the fact that they were heavily allocated to commercial paper of companies which no one would feel comfortable holding equities of, no mutual fund advisors or distributors or media complained about it or brought it to attention. The reason is that herding happens and what we have become familiar with seems comfortable.

 

In any case, the, supposedly, highly sophisticated financial advisors were going to town pointing out how risky equity markets were and recommending debt and liquid mutual funds. They did not realize, despite it staring them in the face, that the holdings of these funds were potentially even more risky. The nature of the instrument with the coupon label and ratings label must have given them comfort. There were other even more “sophisticated” advisors who were exploring mutual funds investing in “unrated paper” since that gave a few bps (basis points—100 bps =1%) more!

 

Summary

To summarize, stay away from the herd and invest in safe companies at prices significantly below their intrinsic values. ACMIIL’s Portfolio mangaement services is designed to do that for equities, but the same principles can be applied to debt instruments. (And no one is claiming that it is perfect!). Further, the portfolio construction, number of different stocks or debt papers, maximum allocation limits, limits on exposure to single sector and industries etc. must take care of the remaining risk factors which cannot be eliminated. Last is the behavioural risks of the investor himself of not panicking and not becoming euphoric at the wrong time.

 

Since we identified this problem nearly a year ago, we have been working on providing a solution to investors and have already done some pilot investments in this. We will soon be bringing the solution to market for potential clients. Keep watching!

 

For more information , write us at investmentz@acm.co.in

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