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Opinion | Triple A will mean ‘highest safety’ from next year

Sebi is making the credit rating agencies accountable for the ratings they give bonds

Debt funds have been under fire for the last few months for holding poor quality portfolios and doing gymnastics with investor money by entering into complicated bilateral arrangements with borrowers that got a higher return, but introduced very high risk to schemes that retail investors thought were safe. The story of encouraging retail investors to use debt funds instead of fixed deposits (FDs) went out of the window in the last 12 months. One part of the problem was not created by fund houses but by credit rating agencies that have been accused of being ‘flexible’ with their ratings and when pushed for accountability, have called them an ‘opinion’, especially when high rated debt paper imploded. The capital market regulator has oversight over these agencies and in a 13 June 2019 circular (you can read it here) has taken a big step forward in getting these agencies to be responsible for their ratings going forward.

The actual work on cleaning up debt funds begins with getting the credit rating agencies to actually do their jobs—of rating debt paper—so that the buyer of the paper and those buying clumps of such papers are aware of the degree of risk they face in terms of the issuer not repaying interest, principal or both. There are three things most relevant for debt fund investors in this Sebi circular. One, Sebi wants triple A to be triple A (and all other rating measures below in a similar manner) no matter which credit rating agency gives it, and irrespective of which sector it is for. This is big progress in terms of standardisation and order in the market because now the way that ‘highest safety’ is defined across credit ratings agencies will be the same. Bond issuers will no longer be able to shop to get a higher rating by going to an agency that has a looser definition of ‘highest safety’. Making the ratings sector agnostic makes the market far more transparent because now the investor does not have to second guess if the triple A for a bank and a triple A for a real estate firm mean two different things. All credit rating measures will have the same safety description no matter what the sector is.

Two, in a possible global first, Sebi is making the credit rating agencies justify the ratings they give by defining what percentage of defaults are allowed for each rating. So a triple A rating, or the highest confidence in the bond in returning both the interest and principal on time, should have a zero default rate for two years. If the credit rating agency has given a triple A rating for a five-year bond, then in the first two years it should not default. In the third year, there can be 1% probability of default. Or all the bonds rated triple A in a cohort should not default for the first two years; in the third year, no more than 1% of all the bonds in that cohort can default. Lower rated bonds have a lower zero default window. Basically, Sebi is making the credit rating agencies accountable for the ratings they give bonds. From next year, when a credit rating agency says that a bond is triple-A rated, it actually will mean that the bond carries the highest level of safety going forward, and not just today. The problem occurs when a rating downgrade happens over the lifetime of the bond putting at risk the money that safety-seeking bond investors had invested. With this rule in place, apparently the first time in the world that a regulator is doing this, credit ratings become forward looking. It remains to be seen if this works on the ground and does not raise the cost of credit rating too much.

What happens if the credit rating firm gets it wrong? Credit rating insiders say that the assessment of the actual behaviour of the debt paper and breaches will be monitored by Sebi. The regulator is reportedly considering a negative point system for getting the rating wrong. Punitive measures could range from a warning, claw back of rating fee or, in extreme cases, a temporary freeze on the rating agency. Of course, this breach must not have happened due to an external circumstance over which the rating firm had no control—for instance, of a court-induced freeze on some mines or a particular interpretation by the court of the income flow of a securitised instrument, but is due to firm or group-specific issues. For example, the press had been reporting on the pain in Amtek Auto for months before the credit rating agencies did a sudden wake-up downgrade and worse, a rating withdrawal. Such behaviour should not happen once these rules are established.

Three, Sebi is changing the way structured obligations (SO) and credit enhancement (CE) arrangements are disclosed. Rating agencies will have to add CE to the rating to show instances of credit enhancements. This is important for those debt funds who were shopping to get the safer SO suffix for their credit enhancement deals. What this means for you is a much cleaner debt market. Both fund managers and financial advisers should be able to make much better sense of debt funds going ahead. Of course, the task of streamlining debt funds themselves is still a work in progress. But in a year, what we saw happening with the equity funds market should happen in debt funds as well.

Monika Halan is Consulting Editor at Mint and writes on household finance, policy and regulation

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