Analysis of the long-term and short-term rating of corporate debt Instruments by credit rating agencies

Abstract

Credit Rating Agencies are tasked with evaluating the credit quality of all fixed income instruments being offered in the market, short-term as well as long-term. They serve as the guiding force for investors in the fixed income securities market, the buyers of bonds and other instruments, by presenting their opinion on the credit risk associated with a certain company, as well as that on comparable companies. Credit ratings also serves as a cost and time effective tool for investors to analyse superior information and identify profit opportunities keeping in mind the associated risk, which would be difficult for them to get access to otherwise. The major credit rating agencies in India are CRISIL, ICRA and CARE, while others are Fitch and BWR to be recognized by SEBI. Studies have shown more lenient standards of rating in India as compared to other emerging and developed markets, as well as a significant time lag in the impact of financial information on the credit ratings of instruments issued by a company (NISM, 2009). The strongest growing class of investments in the Indian economy, the mutual fund industry comprises 52.4% of Debt-fund schemes with an average AUM of Rs.12.9 lakh crores, out of which ~36% is attributed to Liquid (Overnight) fund schemes. 19 Mutual Fund Liquid Schemes exist in the market with an average AUM of above Rs. 1,000 crores, operating under strong guidelines from SEBI with regards to their investment strategies and risk exposure. However, we observe that there is a recurrent alpha, in the range of ~18 basis points to ~67 basis points, being generated as the spread between the highest and lowest returns amongst the top 12 (by AUM size) Liquid Fund Schemes in each quarter over the past 5 years. Theory suggests that higher returns are a reward of accepting higher risks in your investment, however with the entire quantum of these Liquid fund schemes being invested only in the highest rated short-term debt instruments, the variation of ~11% (calculated as a percentage on the average highest Liquid return) between the returns of different schemes poses an anomaly in the market.