There are certain thankless jobs, like keeping wickets in cricket or keeping the goal in football. Unless you perform exceptionally, taking a regular catch or saving a routine attempt at the goal is taken as your job, which does not merit any special appreciation. But any slip draws special opprobrium. However, one failure of a batsman or one missed attempt of a striker does not raise as much of a heckle. Credit rating is one such job. Non-default by an investment-grade rated entity is taken as their job, but one default by an AAA rated company is a failure.
Yes, it is a failure. When an entity/group i.e. IL&FS rated AAA (the highest possible rating) till the other day defaults, and is downgraded to D (default grade) in a span of less than two months, it does raise serious questions on the “opinion” of the rating agency on the repayment ability of the issuer. The institutional nature of ownership of IL&FS, which includes financial institutions and banks, led to a sense of complacency among rating agencies and mutual funds, that it would not go wrong, or if it does, it would be taken care of. When the default broke out, it turned out to be nobody’s baby i.e. none of those institutions infused revival cash into the group. All segments of the market, including investors, analysts, media, other commentators, etc., have come down heavily on the agencies that had assigned the rating. Questions are about the due diligence done by the credit rating agencies, how they were negligent of the cash flow issues of the group and not aware of the other issues in the group that could affect the repayment ability. The flak is understandable. Then why can’t we write off rating agencies?
Any job is done by a specialist. We are treated by doctors, but an occasional wrong diagnosis is possible; professionals also are human and fallible. That does not make us treat ourselves, without going to a doctor. Similarly, rating an instrument/issuer on repayment ability is a professional’s job; we cannot take on their mantle. What is relevant here, is the long term track record and the positive strike rate versus failure rate. Let’s look at the default rate on debt instruments, at various rating brackets, taking data from leading rating agency Crisil. Over a 10-year period, 2007 to 2017, on a one-year rolling basis i.e. one year from the date of observation and then moving to the next date of observation, the default rate on issuers rated AAA is nil. That is, entities rated AAA have never defaulted. On a similar basis, the default rate on AA rated instruments is 0.02%. It means, on a one-year rolling basis over 10 years, the default rate for AA is only 0.02%. Similarly, for A rated securities, the default rate is 0.22%.
As investors, we have no other option but to rely on rating agencies. Sebi had pulled up rating agencies earlier, after the issues of JSPL and Amtek Auto in 2015. After the IL&FS failure as well, rating agencies have been asked by Sebi to explain their failure to detect what is about to happen in the group. There would be some belt-tightening now, post-IL&FS, on the rules of the game of credit rating. As a conjecture, Sebi may ask for dual rating of issuers, rotation of raters, etc. At the end of the day, we expect the rating agencies to perform a basic minimum level of due diligence and tracking of the rated companies, and we expect Sebi to instil fear about regulatory compliance. Otherwise, the purpose of credit rating, which is a reference point for the credit quality of instruments, will be defeated.
The exception to this somewhat helpless look at the alphabets given by raters for gauging credit quality is institutional investors, who would have the bandwidth to do an independent assessment of an issuer. Mutual funds handling a pool of money, being professionally managed, are expected to do a proper due diligence of the issuer and not just rely on the alphabets assigned by the rating agency. Even if a mutual fund commits an error and there is a default by an erstwhile AAA rated entity, the business of the AMC gets impacted as investor sentiments turn negative, which they would like to avoid.
Net-net, as investors, you have to continue to look at the credit rating for gauging the credit quality. Though incidents like IL&FS shake investors’ confidence, hopefully incidents of such magnitude would not recur. One wrong judgment of investment in IL&FS does not mar the entire track record of AMC-fund managers, given the low NPA percentage of about 0.4%. To be noted, DHFL has been downgraded by the rating agency, stock price has been beaten down, but they have not defaulted so far. In the loan against securities (LAS) exposures to Zee Group entities, they have not provided top-up cash or stocks of late, but there has not been any default of maturity or coupon servicing so far. We keep our fingers crossed.