Average Rating Transition Rates for long-term Instruments
Important challenges in SEBI Operational Circular for Credit Rating Agencies, January 06, 2023, which highlight disclosure of Average Rating Transition Rates for long-term Instruments.
Basis our following analysis, it's important to note that the specific approach to addressing these challenges may vary depending on the nature of the study (Average Rating Transition Rates for long-term Instruments), making data available in one place, and the objectives of the analysis. Consulting with (natural) experts in the field or utilizing established methodologies or appointing professional entities to carry out the study can help ensure the accuracy and reliability of your study.
As per SEBI, this circular has got two objectives.
1. To evaluate the performance of a CRA and provide insight on the stability of ratings over a period of time the Transition studies are treated as central. In order to promote transparency and to enable the market to best judge the performance of the ratings, the CRA is directed to publish information about the historical average rating transition rates across various rating categories,
2. So that investors can understand the historical performance of the ratings assigned by the CRAs
But the truth is, CRAs often provide ratings for various financial instruments, including mutual funds, insurance products, and FDs. However, the historical performance ratings assigned by CRAs may not always be easily accessible or transparent to investors. This lack of transparency can make it difficult for investors to evaluate the credibility and reliability of the ratings.
The methodologies used by CRAs to assign ratings can be complex and may involve time-consuming multiple factors. Understanding these methodologies and their implications for historical performance can be challenging for individual investors who may not have a deep understanding of financial markets and rating processes.
To overcome these challenges, investors are expected to consider a holistic approach to investment decision-making. Invest in Mutual Funds because they hire professionals conducting thorough research and diversify their portfolios. Or consulting with financial advisors.
Average one-year transition rates for long-term ratings for the last 5-Financial Year Period as per Annexure 27 we see the following challenges as a whole and our suggestion
Challenges 1: Collecting credit ratings from 7 credit rating agencies for rating migration study:
The main challenge here lies in obtaining credit ratings from multiple agencies and ensuring data consistency. Collecting data from various agencies can be time-consuming and may involve accessing different sources or databases.
Who does this for investors?
Additionally, aligning the data from different agencies and reconciling any discrepancies can be a complex task.
Challenges 2: Selecting a rating for study when an issuer has different ratings from different CRAs:
When an issuer has multiple ratings from different credit rating agencies (CRAs), it's important to establish a consistent approach. Some possible options include:
a. Using a specific CRA's rating: You can choose a particular CRA based on its reputation, methodology, or relevance to the study.
The CRA's reputation is at an all-time low, so this strategy may not work.
b. Considering an average or consensus rating: If available, you can calculate an average rating or use a consensus rating based on inputs from different CRAs.
c. Opting for the most conservative rating: You might decide to use the lowest rating among the different ratings to account for potential higher risk.
A practical one, but who do this?.
Challenges 3: Determining which rating to use for a study when a bank's issuance involves AT1, Tier 1, and Tier 2 bonds:
When analyzing a bank's bond ratings for a study, it's crucial to consider the specific bond type relevant to your research. Each bond type (AT1, Tier 1, and Tier 2) carries its own characteristics and risks. To address this challenge, you can:
a. Focus on a specific bond type: Choose the bond type (e.g., AT1) that aligns with your study objectives and use the corresponding rating for analysis.
b. Analyze ratings for each bond type separately: If your study permits, conduct separate analyses for each bond type, considering the respective ratings.
Challenges 4: Selecting a rating for study when an issuer has different ratings for NCD and NCD with credit enhancements:
When an issuer has different ratings for their Non-Convertible Debentures (NCDs) and NCDs with credit enhancements, you can consider the following approaches:
a. Using the lower rating: Select the lower of the two ratings to be more conservative and account for potential higher risk.
b. Analyzing both ratings separately: If feasible for your study, conduct separate analyses for NCDs and NCDs with credit enhancements, utilizing their respective ratings.
Logu Dhamodara
Author’s personal view.
