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Will Rating Reform Make Investing in Debt Mutual Funds Safe? - Outside View by PersonalFN

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Will Rating Reform Make Investing in Debt Mutual Funds Safe?
Jul 18, 2019

You're probably aware that DHFL has reported a quarterly loss of Rs 2,223 crore in Q4 FY19. Perhaps, the debt markets had anticipated such a period of upheaval back in September 2018 when a fund house sold commercial papers of DHFL at a massive discount.

Can a borrower running in steep loss maintain its creditworthiness? You could answer that with common sense.

But it took rating agencies several months to recognise the problems at one of India's largest private sector housing financial companies. Isn't it perplexing that "AAA" rated papers (so-called top-quality papers) were downgraded to "D" (Default) in a matter of months?

And DHFL isn't a one-off episode. The fiascos with IL&FS, Reliance ADAG group companies, and Essel group companies posed serious questions about the credibility of credit rating agencies as they failed to give investors a heads-up on the rating downgrades.

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The failure of credit ratings agencies has not only affected corporate investors, but also other institutional investors that handle retail money such as mutual funds, pension funds, and insurance companies. As far as mutual funds are concerned, the debt market mayhem has eroded the investors' confidence and now many are shying away from debt funds.

Globally, the ignorance (and malpractices) of rating agencies was in the limelight soon after global financial crisis of 2008 unfolded. Many of global rating agencies have faced civil suits filed against them and paid penalties as well.

SEBI and RBI jointly regulate credit rating agencies in India. Regulators are disappointed that credit rating agencies playing the contrasting role of adviser-cum-rating-agency for companies have failed to protect the investors' interest.

Particularly, the IL&FS case exposed some startling facts. Some of the rating agencies' officials received favours from the default borrower.

Taking cognizance of these developments, SEBI has nudged credit rating agencies to modernise their corporate structure and improve governance practices.

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According to media reports, listed below are the likely changes one may expect in the corporate structure of credit rating agencies going forward:

  • They must have the majority of directors as independent directors on their board.
  • Rating agencies should appoint independent directors only for a 3-year term and one director shouldn't serve more than two terms.
  • There will be a SEBI nominated director on the board of each rating agency.
  • Shareholder-directors can't be appointed in any position of compensation and audit committee.
  • It would be mandatory for the rating agencies to disclose their rate card and whistle-blower policies
  • Credit rating agencies may also have to store ratings related data on servers located in India

Moreover, the regulator has come up with the enhanced disclosure norms for credit rating agencies.

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New disclosure norms:

  • Rating agencies will now have to disclose Cumulative Default Rates (CDR) based on long-run averages (of 10 financial years) and short-run averages (of the recent 24, 36, and 48 months)
  • Credit rating agencies will have to provide a Probabilistic Default (PD) benchmark for each rating category for various periods such as 1-year, 2-year, and 3-year cumulative default rates for the long run as well as short run averages.
  • In case of any credit enhancement, credit rating agencies will now have to explicitly assign the suffix 'CE' (Credit Enhancement) to the rating of instruments.
  • Agencies must disclose sensitivity of the rating in the press release, indicating probable changes in the rating subject to the performance of the company.
  • Now onwards, rating agencies will also have to consider liquidity parameters and the spreads in the bond yields of the rated instrument and that of its relevant benchmark as material factors that could trigger a change in the rating.

While the regulator is busy revamping the regulatory framework, some credit rating agencies have initiated an internal investigation based on complaints they received by the whistle-blower. Such instances highlight that there were possibly some compromises in the credit evaluation processes at the rating agencies.

Will these reforms make investing in debt mutual funds safe?

No!

By nature, debt funds aren't risk free. Nonetheless, rating reforms will definitely help mutual fund houses form comprehensive opinions about issuers of debt. The capital market regulator, in another development, is pondering on altering the mutual fund categorisation norms to make them relatively safe and predictable.

Don't shy away from debt funds simply because default risk has become evident these days. Fund managers of responsible fund houses might have already started taking corrective measures. This includes paring exposure to low-rated papers, not relying excessively on independent credit agencies, and realigning their portfolios with the scheme's defined objectives in mind, among other things.

That said, no categorisation would help unless mutual funds stop relying excessively on the credit ratings assigned by independent credit rating agencies.

Important points for debt fund investors to note:

  • You shouldn't invest in schemes only because they have outperformed their benchmarks in the recent past.
  • Consider your financial goals, risk appetite, and time horizon before investing in any debt-oriented scheme.
  • Following your personalised asset allocation is the key.
  • Ideally, you should invest only in schemes that have a maturity profile matching your time horizon, to avoid negative surprises.
  • Last but not least, invest only in debt schemes offered by mutual fund houses which follow robust investment processes and have adequate risk management systems in place.

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Author: PersonalFN Content & Research Team

This article first appeared on PersonalFN here.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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