In December last year, the media reported that the market regulator was probing how the country’s credit rating agencies failed to spot stress in IL&FS and maintained high ratings till the default on its debt instruments occurred.
The fact that the rating tumbled from AAA to junk in a matter of weeks was a wake-up call for all players in the debt market. After all, should not a rating agency raise timely red flags ahead of a default?
In an attempt to restore faith in the agencies and ensure that they are not caught napping, SEBI implemented some measures. One of them being...
SEBI circular No. SEBI/ HO/ MIRSD/ DOS3/CIR/P/2018/140 dated November 13, 2018, inter-alia, provided that CRAs may treat sharp deviations in bond spreads of debt instruments vis-à-vis relevant benchmark yield as a material event, while reviewing material events. It is reiterated that CRAs shall devise a model to track deviations in bond spreads in line with the said circular.
Guidelines for Enhanced Disclosures by Credit Rating Agencies (CRAs)
SANJAY BAKSHI, Professor at MDI Gurgaon, has a very fascinating perspective on the issue of SEBI requiring credit analysts to watch the bond market.
Professor Bakshi is of the opinion that requiring CRA's to track deviations in bond spreads is a good idea. And this idea is simply an acknowledgement that the bond market may know more than the rating analysts. He goes further and writes that rating analysts should be required to seek useful information from the stock market too.
He shared his views and discussed them on his Twitter handle. They have been collated below in the form of a Q&A.
Why should the creditworthiness of a business be influenced by fluctuations in its stock market valuations?
Let me quote Benjamin Graham.
“Strenuous objections may, of course, be levelled against using the market price of stock issues as a proof of anything, in view of the extreme and senseless variations to which stock quotations are notoriously subject.”
“Nevertheless, with all its imperfections, the market value of the stock issues is generally recognized as a better index of the fair going value of a business than is afforded by the balance-sheet figures or even the ordinary appraisal.”
“A low stock equity not only indicates a quantitative deficiency of the issue; it usually implies qualitative inferiority as well and at times casts doubts upon the accuracy of reported earnings.”
Ponder on those last few words: ….. and at times casts doubts upon the accuracy of reported earnings.
Graham was a wise investor. While he made all his money by exploiting inefficiencies in the markets, be it bond or stock, he was humble enough to recognize that sometimes markets knew more than the analyst. And he explicitly required his students learning conservative bond investing from him to study stock price fluctuations in the companies whose bonds were being studied.
I have always felt this to be a very powerful idea. In my classes, I cite example after example of Indian companies where their stock price decline preceded downgrades from rating companies. And in the last two years, the number of examples has increased significantly. Time and again we find that the stock market almost always knows that there is something wrong with the company well before the CRAs downgrade its debt instruments.
By bringing down the equity market valuation of the company, stock markets, in effect, warn the bond holders to watch out. Their warning means that either earnings are going to collapse or they are fudged and there is fraud going on.
Can the stock market be wrong?
Of course. The stock market will either be right or wrong in its judgement. My key point is that the bond analyst cannot be in a position to ignore the stock price crash. He cannot ignore the signal from the stock market, even if the signal is wrong.
A central tenet of Graham's framework of credit analysis is to do with a study of the relationship between the stock market valuation of the borrower and its debt, and the fluctuation in that ratio over time.
The job of CRAs is to determine the probability of default. And the probability of default in bonds, writes Graham, is not independent of the stock market valuation of the borrower.
How should SEBI require CRAs to include this factor in their analysis and disclosures?
One way to do this will be to specifically require the CRAs to providing a rating rationale whenever there is a sharp decline in market cap of the borrower of more than 25% over a short period of time — say one month.
If, in that rationale note, there is no downgrade, the reasons should be provided. There can be two key valid reasons for maintaining the rating: a general decline in aggregate stock prices or an industry specific issue. But when none of those conditions apply, the analyst must mention that he decided to maintain the rating despite the stock price crash.
My point is that we currently do not require rating analysts to state in their rating rationale that despite a significant drop in market cap, they are maintaining investment grade rating in bonds. I would like them to state that in black and white.
Does any other regulator make such a demand?
It doesn’t matter. Why can’t India take the lead on this? It is a sound idea. And we have a crisis on our hands, and therein lies an opportunity. We don’t have to wait for other regulators to do this before we do it. We can take the lead.
As for objection towards regulators using stock prices for making decisions, let us not forget that SEBI regulations for mutual funds require market to market accounting and its Takeover Code requires tender offers to be anchored to recent stock price of the target company. So, there are plenty of precedents where SEBI relies on stock prices for policy decisions.
What about companies which are debt free? Why should rating analysts downgrade the debt of the borrower simply because the stock price has crashed?
When debt is low, there is an argument that the rating analyst need not look at the stock price because the debt will be paid given the healthy cash flow.
This kind of thinking can be flawed when we are dealing with moral issues, for example when stock price has crashed due to allegations of fraud.
I am not asking rating analysts to downgrade the debt. I am asking them to declare that they are maintaining the rating despite the stock price crash. I am asking them to look at the declining stock price and consider the possibility that something is wrong.
The idea that stock markets sometimes know more than analysts is a well-acknowledged idea in stock investing. Seasoned investors don't just blindly average down when market cap collapses because they fear that the market knows something that they don't. They investigate and buy more only after there is no evidence of wrongdoing. Of course, they could still be wrong because absence of evidence is not evidence of absence.
The rating analyst's position is very similar but with a key difference. If he smells a rat on seeing the market cap collapse, he can make a few calls, do a company visit, confront the management, and so on and so forth. He is allowed to seek “market intelligence” and part of that intelligence should be stock market intelligence and information/clarifications sought from management based on such market intelligence.
Stock market investors do not have the power to question the company except in AGMs and even there managements often do not answer pointed questions. The rating analyst, on the other hand, can demand an answer from management. If the management is evasive and answers unsatisfactorily, he can threaten them with a rating downgrade which may have significantly adverse consequences for the company. And if they still don't co-operate, he can downgrade or withdraw the rating. Or he can put the company on a rating watch with possible negative implications.
Also Read: Sanjay Bakshi: The art of selling stocks