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Impact of Credit Ratings on Debt Portfolios

14-NOV-2018

Author: Team - Edelweiss Partners

When creating a long-term portfolio, an investor is usually inclined towards equity. However, debt as an asset class plays an important role in diversifying the portfolio. You can invest in debt securities like bonds/ debentures etc. or debt funds to have exposure to debt. Even the debt funds typically invest in bonds/ debentures issued by various companies and corporations apart from investing in Government securities. As such, knowing more about the debt securities and how they impact your portfolio assumes importance for you as an investor.

Let us discuss how the credit quality of your debt portfolio can impact you:

1. Returns from your Debt Securities

Just like traditional investment products, even the debentures/ bonds typically carry a fixed coupon rate. As such, you receive periodical interest payments as return on your investments. However, apart from the regular interest payouts, the market value of the debt securities adjusts itself on the basis of prevailing interest rates and the credit ratings.

2. Credit Ratings and your Portfolio

Credit risk is inherent to the debt securities, being the risk of default by the issuer company in respect of payment of principal and interest. Lower the probability to default by the issuer, lower is the credit risk associated with the debt security. This risk is precisely what the Credit Ratings tend to reflect.

Credit ratings are issued by Credit Rating Agencies under various grades like AAA, AA, A, BBB, BB, B, C, D etc. wherein each rating reflects the varying quantum of credit risk. AAA is considered as the rating denoting lowest credit risk, while D denotes that the issuer has already defaulted in the payment of principal and/or interest and carries the highest credit risk.

The credit ratings take into consideration many factors including the company’s sources to service the debt obligations, expected support from the parent company/ promoters, internal accruals of the company, existing debt, balance sheet leverage etc. While the credit ratings are generally a reliable estimate of the credit risk associated, there have been few instances wherein the credit rating agencies have also failed to anticipate the deterioration of the credit quality in some issuer companies including the latest example of a debt default by IL&FS group.

Credit Risk Premium

As the general maxim goes, high returns follow high risk. As the credit risk associated with a debt security increases, the investors do expect some credit risk premium in return. This is the reason why, in a rational market, an AA-rated instrument has to be issued at a higher coupon than an AAA-rated instrument issued at the same time and the same maturity. Similarly, the credit risk premium gets adjusted into the market prices as well through the forces of demand and supply, as there are credit rating actions related to the debt instrument.

Illustration:

An AAA-rated instrument was issued at Rs. 100 at a coupon of 9% p.a. A month after the issue, the credit rating of the issuer company and consequently, the debt instrument is downgraded to AA. The investors in the secondary market will now expect a higher yield from the instrument, considering that now it is an AA-rated instrument and therefore, the price will get adjusted downwards and will trade at a discount to the face value, say Rs. 98. Similarly, in case the credit rating is upgraded, the valuation of the debt security increases, in view of the decrease in the credit risk premium and accordingly, decrease in the yields as per the upgraded rating.

Increased Credit Risk Perception in the Economy due to IL&FS Default

IL&FS Ltd. used to be a AAA-rated entity till 6th August 2018. However, within a month of its downgrade to AA+ and soon after to D, it was hard thing to digest for the investors which mostly included the institutional fund managers and mutual funds that the credit rating agencies had failed to take note of the deteriorating credit quality at an early stage. AAA is assumed to be the credit rating denoting the lowest credit risk of default in servicing the debt obligations and hence, a default from such an issuer created a panic situation amongst the investors in the markets that the financial systems are gripped with liquidity crisis. No wonder, the credit risk premiums have spiked up sharply within a short span of time.

The credit risk premium is generally measured by calculating the difference between the coupon of the debt security and yield of the Govt. Security (G-sec) of the same tenor. AAA-rated securities used to generally quote at a spread of 50-65 bps from the G-Sec, but presently, these spreads for AAA-rated entities have increased to 90-105 bps for varying tenors. This reflected the market adjustments for the expectations of a higher credit risk premium in view of higher credit risk perception.

Even while the investors withdrew Rs. 2.11 lakh crores from liquid funds and money market funds during the month of September 2018, most of it can also be considered as routine treasury management by large corporates, as August 2018 saw an inflow of around Rs. 1.71 lakh crores in these funds. With the Govt. taking control of the Board of IL&FS and RBI staying committed to infuse liquidity into the system, it seems like an ‘all is well’ kind of situation for the Indian financial system.

What should investors do?

While the credit risk is something inherent to the investments in fixed income securities, the investors can certainly mitigate the credit risk for their portfolios by having a well-diversified portfolio with debt securities from several issuers with varied credit ratings. Further, the investors must also ensure that their portfolio is not concentrated in respect of a single security or a single issuer, so that any solitary instance like IL&FS default does not impact the portfolio to a large extent.

Edelweiss Partners offers you an online platform wherein you can check out the details and apply in the public issues of various debt securities including NCDs, bonds etc. It also provides access to the online transaction platform, secondary market quotes related to the existing NCDs/ bonds and financial planning tools to help you achieve your financial goals.

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