NBFC Ratings: How to Interpret Them and What do They Indicate?

Ratings are meant to provide retail and institutional investors with the necessary information, which will help them to determine whether the Issuer will be able to meet his debt obligation on time or not. The rating system works on the principle of Probability of Default i.e. what is the probability that there can be a delay of even one day in repayment of even one rupee from the scheduled payment date. To calculate this probability, a rating agency uses various parameters that can affect whether the NBFC will pay back on time or not.

 

But the question is whether the rating system can measure the strength of the structure correctly?

 

Contrary to popular belief that rating measures riskiness of an instrument, rating infact measures probability of default i.e. what’s the probability that issuer won’t pay on the due date the due amount. Any recovery post default doesn’t normally get factored in the rating.

 

That’s why whether a company raises a senior secured bond or a subordinate bond (which is unsecured junior bond), both these instruments get the same rating even though post default senior secured bonds would be the first to get their money back from the underlying security while subordinate bond holders would stand much below in recovery proceedings.

As I explained above, the rating system works on the probability of event of default. Let me explain this further with the use of an example.

 

Let’s say two covered bond instruments from the same NBFC are to be rated. Everything else being the same, one Instrument says that if the NBFC does not exercise the call option, then it will be a “credit event”, while the other Instrument says that in the same scenario, it will be an “event of default”.

 

What do We mean by Credit Event and Event of Default?

 

Basically, in case of a Credit event, the pool cashflows would start going to the investors and the debenture Trustee/Holders cannot take any legal action against the NBFC until the legal maturity date of the bond. But in the case of the second Instrument, since it is an event of default, the Trustee can take legal action against the NBFC in addition to using the underlying pool cashflows to repay the bondholders.

 

What this means is that in some ways, Instrument 2 is better than Instrument 1 because in addition to utilising pool cashflows you are also taking NBFC to court for recovery proceedings. But since Instrument 2 defines this scenario (and other similar scenarios) as an “Event of Default”, the probability of Default events increases and hence, it receives a lower rating than the first case.

 

In other words, Rating indicates the probability of a default of an instrument and not the probability of the investors getting their money back.

 

Now, keeping this in mind, I would like to compare two of Wint Wealth’s Assets: Wint Gold June 2021 and Wint Gold Bricks Sep21.

 

 

Wint Gold Jun21

Wint Gold Bricks Sep21

Issuer

Dhanvarsha Finvest Ltd.

Dhanvarsha Finvest Ltd.

Issuer Rating

BBB by CARE ratings

BBB by CARE ratings

Instrument Rating

A(CE) by Care Ratings

BBB by CARE ratings

Cover Pool Asset

Gold Loans

Gold + LAP loans

Cover pool size

Minimum 1.25x of issue size

Minimum 1.25x of issue size

Cash Collateral

7% of the issue size

7% of the issue size

Call option

15 months

N.A

Legal Maturity

24 months

15 months

Why did we choose to go with a lower rating for Wint Gold Bricks Sep21?

 

As we can see from the above table, in Wint Gold June 2021, the NBFC is liable to pay money on the call option date, i.e. 15 months from the issue date, and if they don’t exercise the call option, it will trigger a credit event, and SPV will have the right over the receivables from the cover pool which will be used to repay the investors. But since it is not an event of default, the trustee will have to wait for 9 more months to take any legal action against the NBFC.

 

If we had gone with the same structure in Wint Gold Bricks 2021, then the NBFC would be required to have to wait for 81 months (Legal Maturity Date) before they can take any legal action because it has a LAP pool as well, which has a very long maturity as compared to gold loans.

 

In simpler words, if both the assets had the same structure and the NBFC doesn’t honour their obligation on maturity, then in Wint Gold June, Investors will have to wait for additional 6 months, but in Wint Gold Bricks Sep21, they would be required to wait for further 6/7 years. This isn’t acceptable to us. We can bear with a lower rating, but we want the most superior structure.

 

So with the current structure of Wint Gold Bricks 2021, even if the NBFC doesn’t honour their obligation on Maturity Date, the SPV will take legal action right away and try to recover investors’ money. In parallel like in any other covered bond structure the pool cashflows would start flowing back to the investors. But this comes at a cost. The rating for such structures do not receive any enhancement, due to increased probability of the event of default (even though the ultimate risk is lower).

 

Happy Winting!

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