Credit ratings agencies recently downgraded bonds issued by IDBI Bank and Reliance Communications, seriously impacting their stock prices. The counters fell 22% and 40%, respectively over the past one month. To help make informed equity investments, here is what you need to know about a ratings downgrade.
What leads to a downgrade
One of the key reasons why companies face credit ratings downgrade is because of their deteriorating finances, usually high debt levels. It indicates that the company may not be able to service its debt as per schedule or, in some cases, may even default. ICRA downgraded IDBI Bank’s ratings from AA- to A, due to a substantial fall in the bank’s asset quality—which led to high losses.
“While the ownership structure provides comfort, the risk on additional tier-I bonds has increased. The bank may not be able to service the interest on these bonds, in accordance with the stated terms, if it continues to be in violation of regulatory capital requirements,” says Karthik Srinivasan, Senior VP and Group Head, Financial Sector Ratings, ICRA.
Typically, limited improvement in a company’s cash flows that’s riddled with debt leads to downgrades. Not just banks, the same standard applies to capital-intensive and commodity-driven sectors like thermal power, steel, construction, infrastructure and mid-sized telecom entities.
“Taking the eye off the key ratios such as incremental Return on Capital Employed (RoCE) or incremental Return on Assets (RoA) for investment decisions and not initiating action to recover dues in time may lead to downgrades,” says Deepak Jasani, Head, Retail Research, HDFC Securities.
Banks with huge NPAs
Companies with high debt-equity ratio
A high DE ratio indicates that a firm may not be able to service its debt
Firms with poor interest coverage ratio
Higher ICR reflects a higher ability to service debt.
Data is for 2015-16 (latest available numbers). Source: Capitaline, Compiled by ETIG Database. The companies are from the BSE 100 basket.
How does it impact companies
A ratings downgrade hampers the company’s ability to borrow. Lenders may hesitate loaning to such companies and may not even roll-over (refinance) existing debt. “This could in turn impact the future growth plans of the company,” says Jasani. The cost of borrowing also increases for such companies because investors seek higher returns for the additional risk they take.
“To get funds from investors at more attractive rates, these companies need to improve their operational and financial matrices,” says Srinivasan. If the company does not take quick corrective action, it may face further downgrades.
How downgrades impact you
Usually, a rating downgrade is immediately followed by a fall in the company’s stock price, impacting your equity investments in the short run. Even your debt mutual fund investments can be adversely impacted.
“Investors in debt instruments that witness a sudden and sharp downgrade will be faced with losses due to the fall in their prices because of the downgrade,” says Somasekhar Vemuri, Senior Director, CRISIL Ratings.
What you should do
A ratings downgrade is an alarm bell. You need to wake up and take corrective action. However, do not worry if there’s just been one downgrade. “A series of downgrades is a cause for concern, not a single downgrade,” says Jasani. Pay close attention to the recent credit ratings of a bank or a company and also its future outlook, which is given in the rating notes by agencies.
It is an indicator of the likely direction in which the company’s rating is expected to move. For instance, all long-term ratings from CRISIL carry an outlook which gives the likely direction in which the rating is expected to move in the next 12-18 months.
In order to take corrective action, go through the explanation provided by the company in response to its rating downgrade. Will the company be able to honour its promises, within the stipulated time frame? If you think the measures announced are unrealistic, you may exit your investments once the prices recover, after the initial knee-jerk reaction to a downgrade.
If you are a debt mutual fund investor, keep an eye on the ratings of the debt investments made by the fund house. You may check it once every three months. “In case, the exposure to bonds rated below AAA or even AA+ is rising, you should check the pedigree of the companies in which the fund has invested,” suggests Jasani. If the fund’s exposure to lower-rated companies is high, it is advisable to exit the fund.
How to anticipate a downgrade
“If the rating outlook is negative, typically the ratings are likely to be downgraded further,” says Srinivasan. You should also do your own research. For instance, in the case of a bank, find out its non-performing asset (NPA) levels or bad loans. If, compared to peers, its NPAs have been rising, chances are it could face further downgrades.
In the case of a company, pay close attention to its debt equity (DE) and interest coverage ratios (ICR). The DE ratio indicates the proportion of the company’s assets that are being financed through debt, while the ICR indicates the ability of a firm to service the debt and repay it as per schedule. A DE ratio of one is considered optimal. While the higher the ICR, the better is the ability of a borrower to service debt.
“Be careful of betting on highly leveraged stocks on the expectation of a turnaround. In majority of the cases, this turnaround never happens or happens after the investors lose patience and exit,” says Jasani.
