How does rating impact debt funds? All you need to know
Rating agencies are companies that evaluate the financial capabilities and strengths of different companies and government entities, especially their ability to meet their principal and interest repayment on their debt obligations.
The ratings given by these companies act as a signal to the public whether the borrower (the company or government entity) will be able to honour its obligations or not.
If a rating agency downgrades your short-term instruments, it isn’t a big worry if the maturity date is close. However, it could be an issue if the downgrading happens for long-term bonds.
Keeping track of these ratings is essential because all debt instruments, though less risky, have some degree of risks involved such as default risk, interest rate risk, rate risk, etc.
Credit rating agencies like Standard and Poor’s, CRISIL, and Fitch assign letter grades to indicate ratings. Each rating has a different meaning. For example, Standard and Poor’s credit rating varies from AAA (excellent) and D.
Any instrument with a rating below BBB minus is considered a junk bond. You should invest your money into bonds with high creditworthiness and, thus, less speculative.
The ratings become crucial when choosing between bonds of different entities.
What is the role of rating agencies in capital markets?
Assessment of credit risk is done by rating agencies for specific debt securities and borrowing entities. In the bond market, a rating agency assesses the creditworthiness of government and corporate debt obligations.
Two of the three major rating organizations provide ratings to large bond issuers. Rating agencies also give ratings to sovereign borrowers, the largest in most financial markets.
For example, some sovereign borrowers are national governments, municipalities, state governments, and other sovereign supported institutions.
A rating agency gives the sovereign a rating to show its ability to fulfil its debt obligations.
The poor credit rating shows that the loan has a high-risk premium, and it prompts an increase in the interest charged to the individuals and the entities with a low credit rating.
A good credit rating allows borrowers to quickly borrow money from the public debt market or financial institutions at a lower interest rate. At the national level, investors use these ratings given by the credit rating agencies to make their investment decisions.
Impact of a downgrade by a rating agency
Rating agencies downgrade companies primarily because of the danger of default, which can emerge from bad financial performance, declining cash and bank balances, increasing debt, lowering the debt service ratio and worsening business circumstances and prospects.
Any news of the downgrading of any asset, particularly bonds, could cause a drop in the price, resulting in a loss for the investors. Unrealized losses are often known as market-to-market losses.
A downgrade with a ‘rating watch’ might sometimes imply that the instrument will be downgraded further or the default on the debt will be initiated soon.
When a hybrid fund is downgraded, the immunity portion of the portfolio may lose value. When the downgrade is just one notch lower, with an outlook for an upgrade shortly, it can result in temporary volatility in the price.
How to make decisions?
As said above, if the downgrade is for a short-term instrument, you need not worry too much if the majority of these instruments are just one or two months away from maturity.
However, if the downgrade is for long term bonds, you must check how much of your investment is in these bonds. One can get this information from the monthly factsheets.
An exposure of 10% to 15% could be risky. To conclude, whenever a downgrade happens to a debt or a hybrid fund you have invested in, you must take care of the above aspects and then decide to exit or continue from the scheme.