Till date, no long term instrument rated AAA by CRISIL has ever defaulted. For instruments rated AA, the average 3-year default rate is less than 1 percent, which means if you hold an instrument rated AA+ or AA or AA- for 3 years, on an average, the incidence of default has been less than 1 percent.

There are some dark clouds on the horizon: banks are ‘stressed’ with stressed assets, credit offtake from banks by the corporate sector is stagnant due to idle capacities, GDP growth rate in the demonetisation quarter coming in at 7.1% but market participants sceptical about it. In this backdrop, it is interesting to see what message CRISIL’s latest Default Study conveys to us.

Interestingly, CRISIL’s definition of default is any missed payment. That is to say, if an interest payment is not serviced on due date, it is treated as default. In 2016, the overall default rate was 4.2%, similar to 4.1% of previous year, but that is due to high proportion of firms rated less than investment grade. Of the 13,000 firms rated by CRISIL as on December 2016, more than three-fourths had rating of BB or lower, which is less than the investment grade rating of BBB and above. From one perspective, default by companies rated junk should not be alarming; most of the cases of default of 4.2% in 2016 were from sub-par companies. However, from another perspective, more than three-fourths of firms approaching CRISIL for rating being categorized as speculative grade is a cause for concern. Eight years ago, a fifth of the 900 companies rated by CRISIL was BB and lower. The deterioration over eight years shows the pressure on the corporate ecosystem.

In the gloomy scenario discussed above, the saving grace is that the default rate on instruments rated AAA is zero. Till date, no long term instrument rated AAA by CRISIL has ever defaulted. For instruments rated AA, the average 3-year default rate is less than 1%, which means if you hold an instrument rated AA+ or AA or AA- for 3 years, on an average, the incidence of default has been less than 1%. This is not alarming. Even on papers rated BBB, which is just investment grade, the 3-year average default rate is 5%.

The other relevant information from the rating agency is the upgrade-downgrade ratio, which compares the number of upgrades with the number of downgrades in the year. In fiscal 2016-17, the ratio was 1.22; there were 1335 companies upgraded against 1092 downgraded. This is positive as more companies were upgraded. The ratio is similar to 1.29 in 2015-16. There is another variant of this ratio called debt-weighted upgrade ratio, where it is not just the number of companies but the number of companies weighted by the amount of their debt. This ratio is 0.88 in 2016-17, much better than 0.31 in 2015-16. The reason this ratio is lower than the simple number ratio of 1.22 is that companies downgraded are bogged down by large quantum of debt, as compared to companies upgraded, and this pulls down the weighted ratio. The significant improvement in this ratio over previous year shows that the problem of bad debt is bottoming out. This also implies that the NPA problems saddling banks are old legacy issues.

Now that we have seen the rating agency perspective, which shows things are stable to marginally improving, let us now look at what it means for investors. For investors investing directly in bonds, once a company goes into default grade, it is a dilemma. While the logical advice is to sell it off, practically, once the bad news is out, there would not be any buyer or a buyer would quote an excessively high yield i.e. low price. To play it safe, investors should stick to AAA rated bonds where the historic default rate is zero, or at most AA rated instruments where the average default rate is less than 1%.

It is advisable for investors to take the mutual fund route for investment in bonds, as the bond market is largely wholesale, dealing in big lot sizes. Mutual funds offer liquidity in the form of redemption with the AMC, affordable investment sizes, and professional investment management. The credit quality of the portfolio of the fund can be gauged by looking at the credit ratings of the instruments in the portfolio. Since rating of AAA or AA gives us comfort, as discussed above, conservative fixed income investors may confine to funds mandated to invest in highly rated bonds only. The default rate of 4.2% in 2016 was mostly due to companies rated below investment grade junk, where a mutual fund would not invest anyway.

Fixed income oriented investors who have a slightly higher risk appetite may allocate a part of the portfolio to corporate bond funds of reputable AMCs that invest in a combination of AAA, AA and A rated securities, for the higher interest accrual from the credit exposures, as there is a professional team tracking the A and AA rated companies.
Source: http://www.moneycontrol.com/news/business/personal-finance-business/rating-agency-default-study-what-is-in-it-for-investors-2261811.html