Should ratings be sole criterion to make investment decisions?

It was the retirement party of Rakesh Chopra when his ex-boss, who had been specially invited, took him aside for a piece of advice. "Chopra, don't repeat the mistake I committed. Consequent to my retirement three years back, I invested my entire savings in mutual funds and stocks. When the need arose last year for funding my wife's prolonged illness and my son's tuition fees abroad, I was in for some harsh reality check. The market value of my investments had halved and I had to book losses to generate cash. I strongly advise you to put your funds in AAA rated bonds, post office schemes and fixed deposits of PSU banks only post retirement," said his ex-boss.These words kept on ringing in Chopra's mind when he sat down the next morning to plan his portfolio with an investment adviser. He planned to explore putting money in those star-rated companies. But first lets introduce you to one concept: credit rating.

Credit rating

It is an independent opinion on the relative ability and willingness of a borrower to meet the maturing debt obligations in a timely manner. The rating scale starts with AAA (lowest credit risk) and ends at D (default grade, highest credit risk). Going by the normal yardstick, one should always go for the best. So, should all the investors invest only in AAA rated issues? To fathom this paradigm, we have to understand the riskreturn relationship.

Risk-return & risk aversion

Generally, AAA rated issuers/issues offer lower coupon rates i.e. the return for the investor is less as compared to issues rated lower. As one moves down the rating scale, the benchmark interest rates increase. Why so? It is because of the relationship between risk and return — higher the risk, greater has to be the expected return on that investment and vice versa. An investor hoping for higher returns has to embrace the risks that are attached to it.

That brings us to another factor — risk aversion.

Risk aversion

Risk aversion means that, in general, investors tend to choose a less risky alternative when choice exists that will allow for the same degree of benefit. Higher the risk aversion, lower is the risk tolerance. From the perspective of financial markets, investors scout for either similar return for lower risk or similar risk for a larger return.Most investors are risk averse. But how does an investor decide how much risk to be taken? In reality, there is nothing like optimal risk-return trade off. It is often a derivative of various factors like time horizon, liquidity, and some investor specific circumstances

What to look for

Having viewed the investment decisions from this perspective, can we now say that credit rating should be the sole criteria for investment decisions? The answer is clearly no. Credit rating has to be necessarily seen as one of the inputs for informed decision making by investors.For someone in the high tax bracket, AA rated tax free municipal bonds might be an attractive investment option as compared to AAA rated corporate bonds. To investors like life insurance companies, matching their assets and liabilities is paramount. Based on their own actuarial inputs, they could be more inclined towards longer tenure debt as compared to say, commercial banks. However, in the process, they could be required to look at lower rating categories.It would be incorrect to say that they have gambled by not investing in only the AAA rated issues. Depending upon their own underlying objective of investment decision, they try to strike a proper balance between risk and return. In case of banks, if the entire lending is to AAA rated clients only, one can assume the kind of impact it could have on their yield since such borrowers typically get the funds at rates much lower than the bank

The risk-return trade off is extendable to equities as an asset class also. The relative safety of investing in blue chips may not result in highest returns. In case of IPOs also, the IPO grading is an opinion on the relative fundamentals of the company. The investor decision is guided to a large extent by the valuation and risk tolerance. Even a highly graded IPO can fail to enthuse investors if the valuation is too high.Credit rating is a culmination of analysis covering various factors like industry, management , business, financial and project risks. The analysis not only looks at the past performance, but the projected operations also. As such, it does involve certain set of assumptions to arrive at the future estimates.In the dynamic world of business, assumptions can go wrong at times and the projected performance could be lower than projected. Depending upon the changed credit profile and outlook, ratings can potentially change. Hence, an investor needs to juxtapose the resultant changes against investment criterion. So, returning to our example, Chopra needs to look at the risk-return trade off as also a proper asset allocation. As they say, there are no free lunches in this world!