When bonds issued by IL&FS and its subsidiaries defaulted in September, it led to a liquidity freeze in the markets that engulfed non-banking financial companies as well. Credit rating agencies (CRAs) took flak for failing to downgrade the company’s bonds gradually and in advance of the defaults. On November 13, the Securities and Exchange Board of India (Sebi) published a circular that has enhanced the disclosures that CRAs will have to make. And this move was needed, say experts. A Balasubramanian, CEO, Birla Sunlife Mutual Fund explains: “When an IL&FS-kind of situation happens, the methodology of ratings needs a rethink.” According to him, a rating agency should give an idea about the company’s ability to sell assets or raise resources by leveraging the balance sheet or refinancing long-term debt. “They should also reach out to auditors to provide a better picture of the company’s financials,” he added.
Pay heed to debt markets: A widening of spread between the yield of a rated bond and its benchmark will henceforth be treated as a “material event”. When the probability of default by an entity increases, the spread on its bonds widens. When a material event takes place, CRAs must review its credit rating right away. “This rule will force CRAs to be more responsive to signals emanating from the bond markets,” says K Vaidyanathan, lecturer of finance at the Indian School of Business.
Standardise presentation of transition matrix: A transition matrix indicates how ratings have changed over time, an aspect important to evaluate stability of ratings. It shows what percentage of ratings have migrated upward or downward. Sebi wants CRAs to display it for a five-year period under regulatory disclosure. CRAs will have to calculate it on a weighted average basis. The weight will depend on the number of issuers in each cohort (rating category) in a particular year. “We used to file our transition matrix with the Reserve Bank of India. These were also available on our website and were a voluntary disclosure made by us. The regulator now wants us to disclose five-year transition rates to investors under regulatory disclosures,” says Revati Kasture, senior director, Care Ratings.
According to Vaidyanathan, the five-year transition matrix will reflect more correctly the actual probability of a default. “A 20-year transition matrix is less reflective of what has happened in the recent past. Data for five years will reflect recent defaults better,” he says.
Disclosure on sharp rating actions: Sebi wants CRAs to provide data on sharp rating actions to stock exchanges and depositories after every six months. “Sudden and sharp rating actions are not appreciated by investors,” says Somasekhar Vemuri, senior director, Crisil Ratings. CRAs will have to provide data on number of outstanding ratings at the start of the period, number of rating downgrades of more than three notches, number of downgrades from investment grade to default grade, and so on. By comparing the sharp rating actions of different CRAs, investors can get a sense of which CRA’s ratings are more stable, and hence reliable.
Probability of parent support: When giving a rating, CRAs factor in whether an entity will get support from its parent, group, or government to meet its debt obligations. Public sector banks, for instance, get a better rating than they merit because they enjoy government backing. Sebi wants that CRAs should review that rating criterion internally if there is a need to do so. In case a subsidiary is in need of capital infusion, the CRA should check with the holding company if it will provide support. If it is clear that the latter will so so, the CRA should provide the benefit of interlinkages in its ratings. But if there is no clarity, it should not.
Similarly, information on whether rating has been done on a consolidated or standalone basis needs to be made public.
Some lacunae remain: Vaidyanathan says that Sebi’s circular fails to address the issue of wilful defaults, which often happen through related party transactions. “If there is a related party transaction, CRAs should be required to express an opinion on its quality,” he says. While using ratings, investors should be aware of the conflicts of interest that exist. “Rating agencies get their fee from companies. Naturally, they find it difficult to downgrade them,” says Mumbai-based financial planner Arnav Pandya. Moreover, companies shop around for ratings. “If a company is rated poorly by one agency, it is not obliged to publicise that information. It can go to another agency and get a better rating,” he adds.
Investors should not treat ratings from all CRAs as equal. “Use data like default rates, transition rates, and information on sharp rating actions to judge the quality of an agency’s rating and go with the one that is more reliable,” says Vemuri.
Investors should also not depend on ratings alone. They should keep a close eye on the company’s financials and exit if leverage rises steeply, or earnings deteriorate sharply. If auditors point out shortcomings, or several independent directors resign, treat these as red flags.