Credit Risk

Fixed income securities make interest payments at regular intervals and principal payment on maturity. Credit risk of fixed income instruments refers to the issuers’ failure of meeting their interest and / or principal payment obligations, exposing the investor to potential loss of income and / or capital. If the issuer defaults on interest and principal payments then the price of the instrument will be written down permanently and the investor may have to suffer a loss. That is why credit risk may be the most damaging risk, as far as fixed income securities are concerned.

What factors are used to assess credit risk?

Credit rating agencies are financial institutions. Credit rating agencies assess credit risk of bonds and other debt or money market instruments like commercial papers, certificates of deposits etc. based on detailed analysis of their financial statements, market position and operational efficiency and track record of management in making debt payments. Rating agencies use different methodologies of credit analysis for different industries. Below are some examples of key credit risk analysis factors:-

Industry risk:

It is one of the types of credit risk which relates to the size of the industry, its growth prospects, the competitive scenario and demand-supply dynamics, vulnerability to technological change, the importance of the industry to the economy, government policies, entry barriers, profitability, and cyclicality.

Market position:

Market share, pricing power, competitive advantage, customer relationships, brand equity, track record of product development etc.

Operational efficiency:

Operating efficiency is an analysis of a company’s ability to produce goods and services at competitive costs. Key factors common are technology, access to raw material, labour, capacity utilisation and backward and / or forward integration.

Financial risk analysis:

This involves detailed analysis of financial statements i.e. balance sheet and profit & loss account, including key ratios to understand a company’s financial ability to meet its debt obligations. Key ratios are:-

✔ Debt to Equity Ratio or Debt to net worth

✔ Interest coverage ratio: operating income (EBITDA) / interest costs

✔ Profitability margin: operating margin (EBITDA / Sales) or PAT margin (PAT / Sales)

✔ Current ratio: current assets / current liabilities

✔ Return on capital employed (ROCE): EBIT / (Total debt + Total Equity)

How are Credit Ratings used?

Rating agencies evaluate creditworthiness of issuers by assigning credit ratings. The table below describes the credit rating scale used by rating agencies to rate fixed income securities.

Credit ratings can change during the maturity term of an instrument, e.g. an AAA rated paper may get downgraded to A or BBB, a BBB rated paper can get upgraded to A etc. The price of the instrument will go down if its rating gets downgraded and go up if it gets upgraded. A credit rating downgrade does not necessarily imply that the instrument will default but the price of instrument and the NAV of the holding scheme will be impacted.

Credit ratings and yields

Lower rated instruments give higher yields than higher rated instruments. For example, an ‘A’ rated paper can give 200 bps higher yields than ‘AAA’ rated papers. Some mutual funds schemes may invest in lower rated papers to capture higher yields but the credit risk also goes up accordingly. You should understand risks very clearly and invest according to your risk appetite.

How frequently are Credit Ratings Assessed?

Credit Rating agencies usually assess ratings on a half yearly basis. However, if the rating agencies receive material information which may change credit risk outlook of a debt or money market paper, then the rating may be revised irrespective of when the last credit risk assessment was done.

Conclusion

AMCs disclose the credit rating profile of assets for all their fixed income funds in their monthly factsheets and monthly portfolio. You should refer to the latest factsheet to understand the credit risk analysis of a Scheme before making investment decisions. You should also refer to the AMC factsheets on a regular basis (e.g. monthly, quarterly, half - yearly etc.) to monitor the credit quality profile of your investments. You should also consult with your financial advisor before investing.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.