Don’t blindly rely on credit ratings while investing in NCD issues

Non-convertible debentures, or NCDs, which are used by companies to raise capital, are financial instruments where people make investments to earn regular interest at a fixed rate for a specified period.

To assess the quality of an NCD issue, the most widely used tool is the credit rating, which is issued by rating agencies. Generally, issues with an AAA rating are deemed the safest. Further, experts suggest that retail investors should not go for issues with ratings below AA/AA+.

However, there are many instances where the credit rating agencies themselves were questioned.

Mint It was reported on Tuesday that markets regulator, Securities and Exchange Board of India (Sebi) may revoke the license of credit rating agency Brickwork Ratings due to lack of independence of ratings committee and may lapse in the following procedures during rating instruments (read here)

So, what investors should do while looking at the credit rating for investing in NCD issues.

According to Nishith Baldevdas, founder and SEBI-registered investment advisor, Shree Financial, the first thing that investors should keep in mind is that the rating is the opinion of the rating agencies and not an absolute guarantee of how the company will perform.

“In the past, even AAA-rated issues like DHFL and IL&FS were missed. Investors in such issues later realized that they would not get 100% of their investment back,” said Baldevdas, who does not recommend investing in NCDs.

According to the financial advisor, the better judge of the NCD issue is the quality of the business, sound management and how diversified the company is.

“If it is a large conglomerate with good corporate governance and well diversified business, the risk factor automatically gets reduced. Because if a business fails, the credibility of the owner is at stake, so he will try to settle investors’ money either by liquidating other business verticals or by taking loans from other entities,” Baldevdas said.

Harshad Chetanwala, a SEBI registered investment advisor and co-founder of MyWealthGrowth, believes that credit ratings are important in the sense that they give you a sense of the quality of the issue.

“However, there have been occasions where there was no synergy between ratings and organisations’ behaviour, and there has always been a question on the spirit behind how ratings are being done. But investors and individuals need a strong source on the outlook for the company,” he said.

Chetanwala suggests that investors should not get fooled by the current ratings and should look at the historical ratings of the last one or two years. It gives an insight into how the company has performed over the years.

In addition to looking at the ratings (AAA, AA, etc.), investors should also consider the company’s outlook as per the rating agencies. Generally, a ‘stable’ outlook means a low probability of a rating change in the near to medium term, while a ‘negative’ outlook indicates a high probability of a downward rating revision in the near to medium term. Persistent negative attitudes can be a warning sign.

Further, apart from looking at the credit profile of the NCD issuer, investors should also check the quality of the credit rating agency.

“There are some reputed and established credit rating agencies in India like ICRA Ltd., CARE Ltd. and CRISIL Ltd. which investors must rely on. However, the research has to be done either by the advisor or the investor. The key factor is that investors should not blindly rely on the existing agency ratings while investing in NCDs.”