Photo: Bloomberg
Photo: Bloomberg

Understanding credit risk in India

Publicly traded firms in India generally dobetterin terms of credit default risk compared with their peers in Asia

As India’s financial markets become more dynamic and the economy continues to evolve and diversify under the Narendra Modi government, investors also need to evolve the way they assess credit risk.

Ratings from credit rating organizations are a traditional measure of credit risk and a valuable source of information. Credit risk assessment typically involves looking at the financial ratios of the company as well as consultation with management teams.

The ratings process is designed to be a long-term credit view, based on a deliberate consultative approach. The problem for investors is that credit risk can change rapidly while traditional ratings can be slow to reflect real-time dynamics.

Investors, lenders and regulators that need to stay on top of credit risk and gain a more far-sighted view of potential risk earlier in the cycle need to adopt additional approaches.

One solution for investors who care about the default probability of a company is to tap more nimble quantitative default risk analytics. These analytics use an equity markets-derived view of credit risk that can be generated and tracked daily to rapidly identify emerging trends.

A recent Bloomberg report (Credit Risk for Indian Corporates, 2015) pointed to interesting insights that investors can gain by applying such a model to credit default risk analysis for Indian firms.

For example, we found that while the median default risk of Indian companies has improved since 2008, their risk has also remained higher than for those of other Asian, US and European firms, a useful insight for investors scouring global markets for local plays.

The report also demonstrated that publicly traded companies in India are generally better in terms of credit default risk compared to publicly traded companies in Hong Kong, South Korea and Singapore. In general, the median risk of publicly traded companies is slightly higher in those three countries than in India—potentially important information for investors as they narrow to a specific regional focus.

Insights can also be generated at a sector level within a specific country, for example in the Indian banking sector, where there are 43 publicly traded banks of which 26 are public sector. The analysis in our report pointed to public sector banks having higher default risk than private banks, particularly since 2010.

This is not surprising given the constraints on public sector bank activities and the mandates they have on who to lend to. Greater freedom among private sector banks means they have gravitated towards lower risk clients.

On a wider multi-sector basis, an equity driven view of credit risk also demonstrated that bigger Indian firms tend to have lower default risk than smaller firms. In other words, size does matter.

When comparing large-cap companies of similar size in India, we found that public sector corporates tend to be more leveraged than private firms. These private sector firms tend to generate higher profitability and deliver higher shareholder returns as well.

Another benefit to investors of using equity driven credit risk analytics is that it gives a forward view, surfacing possible predictors of risk significantly earlier in the cycle than traditional ratings processes. Equity prices are, in general, very liquid and tend to reflect the aggregate impact of many people looking at the future fortunes of the company based on expected revenue, growth and profitability—factors that determine expected cash flows. Those cash flows go towards paying off debt and other expenses.

There is a relationship between the expected fortunes of the company moving forward and the quality of the company, which indicates the credit health of the company and the future expected default risk.

Such insights are powerful because they factor in three key drivers—market cap, volatility and leverage.

These insights are valuable regardless of whether you are a foreign investor investing in bonds or the equity of a company or a domestic investor. All investors are dealing with the same set of cash flows under equity driven analytics. The inherent default risk of the company is identical for both.

The health of a country’s financial sector has far-reaching implications for its economy. With India’s focus on economic growth and its rising importance to the global investment community, there is a greater need for investors to enhance their credit default risk analysis beyond traditional models. The more timely, predictive and frequently updated data that can be generated by equity driven credit risk tools better equips investors to make important risk-based decisions. That’s good for investors and for India’s financial markets.

Rajan Singenellore is global head of Bloomberg’s default risk and valuation group.

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