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Bond Rating Variability and Methodology

Volume 16, Number 3 Article by Sanjay Sehgal & Mamta Arora September, 2004

Bond Rating Variability and Methodology: Evidence from the Indian Bond Market :

Credit rating is an indicator of the current opinion on the capability of capital to service its debt obligations in a timely fashion. It is a useful source of information for investors, companies, banks and other financial intermediaries. While the various bond rating areas have been extensively evaluated for mature markets, similar evidence for emerging markets such as India is limited. In particular, the issues relating to bond rating variability over time and the consistency of bond rating methodology have been ignored.

In an attempt to fill this lacuna, Sanjay Sehgal and Mamta Arora conduct a two-part study. In the first part, which deals with bond rating variability over time, the time-series variability of bond ratings has been analysed. The issue is also addressed sector-wise and industry-wise. A separate analysis has been carried out for the two leading bond rating agencies - CRISIL and ICRA. The second part relates to consistency in bond rating methodology adopted by rating agencies.

The results indicate that bond ratings are becoming extremely variable over time and the majority of these rating changes are on the downside, with price risk implications for investors. While bond rating variability is high for both the manufacturing and the financial sectors, the figures are relatively higher for the latter. Rating changes also seem to have an industry pattern with a greater concentration in industries more affected by economic slowdown and global competition. The findings for consistency of bond rating methodology are also not encouraging. While the key financial ratios do not vary for companies belonging to the same rating class, they also do not vary across companies belonging to different rating classes. This points at probable weaknesses in rating methodology as the important financial factors fail to discriminate across rating classes. Perhaps the subjective judgments of rating analysts taint the relationship between bond ratings and key financial factors. Inconsistency in bond rating methodology may partly explain the increasing bond rating variability over time.

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