Credit risk

Lend money and two things can go wrong: the price of the loan can move against you, or the borrower simply may not pay. The second is credit risk.

It is the reason a lender asks what a borrower is worth before lending, and the reason two bonds paying the same coupon can be worth very different amounts. In India the assessment is outsourced to credit rating agencies, which must be registered with SEBI and work under the SEBI (Credit Rating Agencies) Regulations, 1999.

A rating is, in the workbook's own words, an exercise that converts into a symbol the ability and willingness of a company to service the instrument it proposes to issue.

SEBI has standardised the symbols so an investor can read the level of credit risk straight off the label. For long term instruments — original maturity exceeding one year:

Modifiers + and − may be used from AA down to C to show standing within a category. Short term instruments use a separate scale, A1 (lowest credit risk) through A4 (very high credit risk and susceptible to default), then D; only the + modifier applies there.

Crucially, a rating is dynamic, not static. SEBI requires agencies to monitor the factors affecting an instrument continuously and to reassign the rating as credit quality improves or deteriorates.

A debt scheme has net assets of Rs 1,200 crore across 48 crore units, so its NAV is Rs 25.00. Rs 60 crore of that — 5% of the portfolio — sits in the non-convertible debentures of one NBFC, rated AA when bought.

The issuer stumbles and a SEBI-registered rating agency downgrades the paper below investment grade. That is a credit event, and if the Scheme Information Document provides for it and the trustees approve, the AMC carves the holding into a segregated portfolio at ISIN level, effective from the day of the credit event:

The investor's Rs 25.00 has not vanished — it has been split into a Rs 23.75 piece that still trades normally and a Rs 1.25 piece that is frozen. No subscription or redemption is allowed in the segregated portfolio, so the AMC must list its units on a recognised stock exchange within 10 working days to give an exit.

If the issuer later settles at 40 paise in the rupee, Rs 24 crore is recovered and distributed immediately in proportion to holdings — Rs 0.50 per unit. The other Rs 0.75 was the credit risk, realised.

Chapter 3 (Characteristics of Debt Securities) defines credit risk and then reproduces the full SEBI rating scales, long term and short term, symbol by symbol. Chapter 11 (Operational Concepts of Mutual Funds) picks the thread up in segregated portfolios, where a credit event is defined as a downgrade below investment grade by a SEBI-registered CRA. Expect a question that hands you a symbol and asks for the level of risk, a question on which categories take the +/− modifier, and a question on what triggers a side pocket.

• AAA is lowest credit risk, not highest. The scale runs from safety at the top to default at the bottom, and the wording in the options is often inverted deliberately.
• The +/− modifiers run from AA to C only on the long term scale — not on AAA, and not on D. On the short term scale only + is used, A1 to A4.
• D is not merely "very risky". It means the instrument is in default or expected to be in default.
• A rating is not permanent. SEBI requires continuous monitoring and reassignment; the workbook is explicit that credit risk associated with a borrowing may change over time.
• A provisional rating is not a final rating — it must be prefixed "provisional" in the rating letter, press release and rationale.
• For unrated debt of an issuer with no outstanding rated paper, a segregated portfolio may be created only on actual default of interest or principal, not on a credit event.
• Rating grades the instrument, and long term and short term instruments use different scales. Do not read A1 as a weaker cousin of AAA.