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We explain the workings of credit ratings and how they can help investors make decisions when buying debt funds.
A
credit rating, in simple terms, indicates the probability of
a borrower repaying the debt or defaulting on debt payments. Debt
payments
include both the interest and the principal. A poor rating indicates a
high
probability of default on debt payments. A
credit rating is assigned to either a debt security or a
borrower by a credit rating agency. Globally there are three major
rating
agencies: Standards & Poor’s, Fitch and
Moody’s. In India, there are four
ratings agencies: CRISIL, ICRA, Fitch and CARE. Except for CARE, all
three
rating agencies in India are subsidiaries of the major global rating
agencies.
Every rating agency has its own scale of credit ratings to indicate the
probability of default. Government
securities (or GILTS) have a sovereign rating (SOV),
indicating absolutely no risk of default for the citizens of that
country. Need for Credit
Ratings Although
it is not mandatory for a debt security to have a
credit rating, most debt securities do get a credit rating from one of
the four
agencies as this provides a standard that investors can use to compare
debt
from different borrowers more easily, without spending too much time on
analysing
the credit-worthiness of the borrower. A debt security that has a
credit rating
is more easily bought or sold than a debt security that does not have a
credit
rating. Credit
ratings also determine the rate at which the borrower
can borrow from the market. A debt security with AAA can borrow at the
lowest
rate in the markets, which will be slightly above the Government
securities
rate of the same maturity period. As one moves down the rating scale,
the
borrower needs to pay a higher interest rate to compensate for the
higher risk. Credit Ratings for Debt
Mutual Fund Investors Debt
mutual fund investors must also understand the significance
of the credit ratings before they invest their money into a debt fund.
A debt
mutual fund invests in many debt securities with different credit
ratings. Investors
should make sure they are comfortable with the credit ratings of debt
securities that the fund invests in, otherwise they would be taking
unwarranted
risk which may later lead to losses. Long
and short term debt securities have different ratings.
Long-term debt refers to the debt wherein the maturity of the security
is
greater than one year. Short-term debt refers to debt whose date of
maturity is
less than one year. Different ratings are needed for long and short
term debt
because long-term debt tends to be more sensitive to changes in
interest rate than
short term debt. Long-Term Debt
Ratings The
long-term credit rating scale ranges from AAA to D. AAA
indicates a low probability of default and D indicates that the
borrower is in
default, or will most likely default. An
additional ‘+’ or ’–‘
sign is affixed to the ratings (except for AAA and D) to
indicate higher or lower quality among the debts of the same rating.
For
instance, a debt security rated AA+ has better quality than AA. A debt
security
rating of AA- is of lower quality than a rating of AA. The
long-term rating
scale is pretty similar across all four rating agencies. AAA
is the best credit rating possible for a non-government
debt security. This rating indicates that the borrower will repay the
principal
and the interest on time and has adequate reserves to fulfill debt
payments.
Ratings from AAA to BBB- are considered investment-grade ratings. Debt
securities
rated from AAA to BBB- are mostly purchased by mutual funds and
institutional
investors, as they are safer than speculative debt securities. Any
rating below BBB- (i.e., BB+ and below) is considered speculative
grade. These debt securities are for people who can take high risk as
the risk
of default is considerably higher in comparison to investment-grade
debt securities.
The returns are also considerably higher than investment-grade debt
securities.
Such speculative securities are more commonly known as high-yield
securities.
Globally, there are special mutual funds called high-yield funds that
invest
into these speculative-grade securities. As of now, there are no
high-yield
mutual funds in India. Any
security with a ‘D’ credit rating will default or
has
already defaulted. These securities are for investors who are
comfortable with
very high risk. Most issuers of D-rated debt instruments are sick
companies in
the process of financial reconstruction. If
the issuer is able to recover financially, then the D-rated debt
security
holder gets returns of high magnitudes. The
long-term credit ratings for all four rating agencies
are shown in Table 1
Short-Term Debt
Ratings While
long-term debt ratings are similar
across the four
ratings agencies, short-term debt ratings vary far more. The
length of the scale is different for
different ratings
agencies. The rating scale ranges from 1 (highest quality) to 5 (lowest
quality). The rating agency can use ‘+’ or
‘-‘
to indicate better or lower
quality. The use of the signs is more common in the long-term debt
ratings than
in short-term debt ratings. Investors
into average-to-low quality (a
rating of 3 and
above) short-term bond funds are at a disadvantage to long-term bond
fund
investors. Suppose a long-term debt security is given a rating of D,
there is some
hope, given the longer maturity, that the company might be turned
around or
restructured, thereby providing a good return. With short-term bonds,
the shorter
maturity period means there is less time for such a turnaround. So
investors are advised to invest in
short-term bond funds
with most debt securities with ratings of 1 and 2. Investors with
higher risk
appetites may invest in bond funds with debt securities with ratings of
3 or
more.
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Manjunath Gaddi is part of iFAST Financial India Private Ltd. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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