Don’t go blindly by credit ratings when investing in NCD issues

Debt investment is not about returns, but capital protection. Therefore, it is very important for investors to understand the risks completely before putting money into various debt instruments.

Non-convertible debentures, or NCDs, which are used by companies to raise capital, is one such financial instrument, where people invest to receive regular interest at a certain rate for a fixed tenure.

To judge the quality of an NCD issue, the most widely used tool is the credit rating, which is issued by rating agencies. Usually, issues that are rated AAA are understood to be safest. Moreover, experts suggest that retail investors shouldn’t dabble into issues that are rated below AA/AA+.

However, there have been instances where questions were raised on the credit rating agencies themselves.

Mint on Tuesday reported that markets regulator, the Securities and Exchange Board of India (Sebi) may revoke the license of credit rating agency Brickwork Ratings due to lack of independence of the rating committee and lapses in following procedures while rating instruments (read here).

So, what should investors do when looking at the credit rating for investing in NCD issues.

According to Nishith Baldevdas, founder, Shree Financial and a Sebi-registered investment adviser, the first thing that investors should keep in mind is that ratings are the opinion of the rating agencies and not the absolute guarantee of how the company will perform.

“In the past, issues that were even AAA-rated such as DHFL and IL&FS defaulted. Investors in such issues later realized that they won’t get their 100% investment back,” said Baldevdas, who doesn’t recommend investing in NCDs

According to the financial adviser, the better judge of an NCD issue could be the quality of the business, sound management and how diversified the company is.

“If it is a big conglomerate with good corporate governance and well-diversified business, then the risk factor gets reduced automatically. Because if one business fails, then owner’s credibility is at stake, so he or she will look to settle investors’ money by either liquidating other business verticals or taking loans from other entities,” Baldevdas added.

Harshad Chetanwala, a Sebi-registered investment adviser and co-founder of MyWealthGrowth, believes that credit ratings are important from the point that they give you a sense of the quality of the issue.

“However, there have been occasions where there was no sync between ratings and how the organizations behaved, and there has always been a question on the spirit behind how the ratings are being done. But investors and individuals do need a strong source on the outlook of the company,” he said.

Chetanwala suggests that investors shouldn’t get carried away by the current rating and look at the historical rating of the past one-two years. This gives an insight into how the company has performed over the years.

Apart from looking at the ratings (AAA, AA, etc.), investors should also consider the outlook of the company as per the rating agencies. Generally, a ‘stable’ outlook means a low likelihood of rating change in the near to medium term, while a ‘negative’ outlook indicates a high likelihood of a downward rating revision in the near to medium term. A consistent negative outlook could be a warning sign.

Moreover, apart from looking at the credit profile of the NCD issuer, investors should also check the quality of the credit rating agency itself.

“There are a few reputed and established credit rating agencies such as Icra Ltd, Care Ltd and Crisil Ltd in India that investors should look to rely on. However, the research has to be done either by the adviser or investor. The key factor is that investors shouldn’t blindly go by the current agency rating while investing in NCDs,” said Chetanwala.

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