Mumbai: Who can spot bad credit from a mile? Apparently share prices of companies are a good indicator of whether the financials of the firm are in trouble. This is Reserve Bank of India’s (RBI) observation in its financial stability report.

Bond yields have been a reliable indicator of whether a company’s capacity to repay its debtors has eroded over time. Even so, the central bank found that yield movements are largely minimal until the bond is downgraded to junk. Therefore, investors may not be able to realize the extent of deterioration in a company’s financials.

The RBI is not entirely wrong. In fact, elsewhere in the report, the central bank has slammed rating agencies from misleading investors. “Some instances of possible ‘rating shopping’ can still, however, be ascertained by looking at the dynamics around rating withdrawals where outstanding rating issued by a CRA was withdrawn and a new rating was provided by a different CRA (within 3 months of each other)," the report noted.

The central bank’s staff observed two companies, one a core investment company with several subsidiaries and one that is undergoing resolution currently. Default by a subsidiary hardly impacts the bond yields of the core investment company unless the holding company’s ratings are downgraded. In fact, the bond prices of the subsidiary that was downgraded to default rating showed some resilience even after the downgrade. In short, bond investors ignored the decaying of the financials of the company. On the other hand, share prices of the listed subsidiaries have shown early signs of the trouble.

Recall that in September 2018, share prices of non-banking financial companies saw massive drop in a single day after a mutual fund sold bonds of Dewan Housing Finance Ltd (DHFL) at a price indicating high stress. Eventually DHFL has wound up under insolvency proceedings. At that time, yields on other bonds issued by DHFL had hardly moved. Bond yields surged only after the company was downgraded to junk rating.

But one case may not be enough to establish that equity prices are a superior indicator of stress. To be sure, the RBI notes that not all movements indicate worsening financials and that share prices are volatile. But it is willing to bet that in most cases, they are a fair indicator of stress.

On a broader note, the central bank’s case points out to the shortfalls of the bond market in assessing credit risk. Marred by illiquidity, corporate bonds in India lack in responding swiftly to changes in credit quality. Until the bond market becomes agile enough to punish borrowers faster, investors would do well to keep an eye on the stock market.

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