Archive for February, 2009

Update: We have the correct link. Thanks to commenter Chaitanya!

So the Pension scheme, which starts on April 1, will allow everyone to dictate where their pension money is invested, in three areas - "E" being equities (currently Nifty indexed), "G" meaning G-Secs, Liquid funds etc. and "C" being medium risk (Credit risk on fixed income instruments).

What is fantastic in there for "C" is the disregard for Rating agencies completely. I have total disrespect for all the rating agencies: S&P, Moodys and Fitch most of all. S&P has just downgraded India - for heaven's sake, we are nowhere close to Europe, the US or even Citi and GE, but all of those enjoy a better rating? And we should believe them, despite their rating subprime CDOs as AAA even when they were on the verge of default? And after keeping Lehman and Enron's rating right till the time they went bankrupt? C'mon. They are either incompetent or arrogant - whatever it is, let's cut them out. They must be made irrelevant.

That's why I like this part:

3.1.3 Asset class “C”

This last asset class contains bonds issued by any entity other than the Central Government. Here, the issuers can be state governments, municipal bodies, state government PSU/PSE like electricity boards, and private corporations. Unlike with equity, these are fixed income instruments with fixed maturities. The risk of these assets is limited to the default risk of the issuer and is, therefore, more restricted compared to the risk of equity.

However, the risk of default varies widely across issuers. In the early phase of NPS, it would be prudent to consider some restrictions on issuers whose bonds could be part of Asset Class “C”.

Traditionally, investment restrictions have been put in place based on the credit rating of the bond issued. However, while we do consider that there is value in a bond that has a credit rating compared to a bond that does not have a credit rating, the EG does not consider it either necessary nor sufficient to include a minimum credit rating for a bond that NPS funds can be invested into.

There are several reasons for this:

1. Domestic and international events observed over the last decade of financial market activity have given pause to selection criteria based solely on credit ratings. The two main observations are:

• Credit ratings take a long time to adjust to information present in the market about the credit worthiness of any given bond. Some of the more stark examples of this are that of the credit ratings of Worldcom and Enron. The credit ratings on their bonds adjusted downward far later than the stock prices of their shares.
• More recent events have shown that credit rating agencies are vulnerable to agency conflicts between the rater and the rated.

The recent crisis of the problems that have arisen in the financial institutions that have led to the global financial crisis is another case in point.

In isolation, such events are not damaging – it is not possible for any financial measure to be perfect predictors of credit quality. However, a sole/primary dependence on credit ratings alone has been shown to be flawed as a strategy in setting investment criteria primarily because of the manner in which it skews the incentive of the PFM.

2. One of the key lessons from the financial sector crisis of the last several years is that if there are strong prudential risk monitoring and management rules, fund man agers tend to obey them blindly at the cost of developing their own internal risk management systems.

Every fund manager has internal prudential investment norms that are set and ap- proved by the board of the AMC. These become the risk-return tradeoffs which become the cornerstone of investment decisions made by the PFMs.

Instead, the EG consider a more broad-based set of selection criteria for credit linked investments. These selection criteria are biased towards liquidity of the instruments and the availability of frequent information updates about the issuer based on which the PFMs can have a more relevant assessment of the credit quality of the bond issuer.

We observe that there is a far larger amount of information that is available about the earnings and performance of bond issuers that also have shares listed and traded on public exchanges. For such issuers, which today include a good representation of public sector enterprises and public sector undertakings (PSE/PSU), fund managers will have access to standardised and audited information. On the other hand, fund managers will not have access to similar kinds of information for those entities which are not listed companies.

This set includes issuers such as state governments, municipalities, as well as most of the infrastructure projects that are available for investment today and, likely in the near future as well.

We recommend that for entities that issue bonds which have better disclosure of balance sheet and performance data, the selection criteria for NPS PFMs to invest in their bonds can be broader based than only credit ratings.

In this, we follow in the footsteps of the credit risk measurement practices that are increasingly gaining credibility all across the world. When prices are available from liquid secondary market trading, credit measures based on this price becomes an indicator of changes in credit quality of the issuer. Such measures lead changes in the traditional credit rating by a wide margin. Thus, fund managers that depend upon price-based measures can adjust for changes in credit quality of the issuer much earlier than fund managers that depend only upon the traditional credit ratings.

The evidence has led to credit ratings models having adopted price based measures to update the credit quality of issuers in their ratings models. As mentioned earlier, the advantage of the stock-price based credit measure is that it is a more real-time measure of the credit worthiness of a bond than the credit rating itself. The caveat to using the credit measure based on stock prices is that the price based information depends upon the liquidity of the stock of the issuer: the more liquid the share, the better the price information as an early and credible indicator of credit quality of the issuer. However, within this caveat, we recognise that prices and the information in listed entities is a valuable source of input for valuation of securities by the PFM. We therefore, recommend that the selection criteria for listed and non-listed entities be differentiated, with a lower emphasis on the credit rating where better information is available.

Recommendation

With the above considerations in mind, we recommend the following as the non-central government entities, whose bonds can be permitted into the Asset Category “C” for NPS investment:

• All state government bonds that are explicitly guaranteed by the state government.
• All state government bonds that are rated by a credit rating agency. There is no restriction on an “acceptable minimum” credit quality – the choice of investment is left upto the PFM to decide.
• All credit rated bonds/securities of
  1. “Public Financial Institutions” as specified under Section 4(A) of the Companies Act, and
  2. “Public sector companies” as defined in Section 2(36-A) of the Income Tax Act, 1961 ; the principal whereof and interest whereon is fully and unconditionally guaranteed by the Central Government.
• All municipal bodies/infrastructure funds bonds that are rated by a credit rating agency. There is no restriction on an “acceptable minimum” credit quality in the case of municipal bonds as well – here too, the investment choice is left to the prudence of the PFM.
• Bonds be permitted for NPS investment of all firms (including PSU/PSE) that have shares listed on a stock exchange with nation-wide terminals, and:
  1. Have a market capitalisation of over Rs.5000 crore (as on 31st March),
  2. Which have been traded for at least three years,
  3. Whose shares have an average trading frequency of at least 95% for a period of the last one year on the exchange.
  4. Whose top management as well as the board of directors of the company have no legal/regulatory charges against them.

  The stock-market based filters for selection of corporate bonds for NPS “C” asset investment also implies that the stock market indicators can be used for valuation of the “C” assets. This will be an improvement in the current valuation framework that is based on credit-rating downgrade since the stock market price can be a more real-time measure of credit quality compared to the credit rating.

• In addition, exposure to any single bond of an entity should not exceed more than 5% of the total funds invested by the PFM in Asset Class “C”.
• The total exposure to bonds by any single entity should not exceed more than 10% of the total funds invested by the PFM in Asset Class “C”.
• Lastly, the total credit exposure of all the NPS funds invested in the debt of any permitted entity should be limited to a concentration of less than 5% of the total debt of that company.

Now it is likely that these rating agencies, with the power of their money, try to influence the government and the PFRDA to change this. Plus, for pension fund managers, it is a good curtain to hide behind, and say that they invested in something that was rated highly; that absolves them from the responsibility of good credit checks.

I urge you all to support the current proposal - of total irrelevance of a rating. We must remove the concept of rating entirely from legislation - only if someone wants an "opinion" they will look at a rating, it is not a necessary thing; from a regulation standpoint, there should be ZERO reason to pay these incompetent or arrogant people our money.

How to do it? Please mail or contact the PFRDA at their contact page. Best way of action is to mail kamal.chaudhry@pfrda.org.in. If you like, CC me in (deepakshenoy@gmail) and I will collate the response list; just in case the rating agencies create a fuss, we must be united on the other side.