Why do defaults happen? Where do things go wrong? What can one do to prevent mishaps? The answers are neither simple, nor complex. To understand this, let’s delve into a few issues that underline our credit philosophy.

If you ask a credit analyst, it boils down to analysing a set of parameters to arrive at one thing—how much and how steadily can a company generate cash flows to meet its debt obligations. For manufacturing companies, is the business cyclical? Does it need to do capex for old plants or integration? How efficient is it in terms of cost of production or capital costs? All this link to predictability of cash flows and link that with the company’s financial position—can there be debt obligations that will come up when commodity prices are low and cause liquidity problems?

Sometimes, working capital is the enemy, too. Think power companies; the biggest risk for them is not getting timely payments from discoms. If it is a finance company, is the asset quality good and without undue risk so that the assets can naturally give the liquidity to pay back borrowings?

Their ability to price risk well is also an important factor. If they get adequate reward for taking a risk and keep costs low, their pre-provision profits will allow them to provide for credit losses.

Is there regulatory risk? Think sugar/fertilizer and price controls. Around these we use a host of financial parameters to quantify these into numbers for measuring creditworthiness.

So far, so good. However, mistakes happen. Why is that?

When one invests, we use past data/patterns to predict the future. However, the future can unfold very differently. This is what happened to protected commodity companies post liberalization; they could not withstand the impact of imports.

However, many defaults are due to governance issues by the promoters and management. For this, one needs to go beyond an audited set of numbers or a rating agency opinion, both of which are usually taken as sacrosanct by the market till things go wrong.

For every company, it is important to run smell tests—reference checks from the markets/lenders, opinion of equity teams for listed companies, checks with competitors, media checks, etc. We also need to assess management quality and promoter experience, and how they react to changes.

A promoter’s attitude is important. Is the promoter aggressive? Are they perpetually in need of debt? Do they need to take out dividends from good companies for their investment plans in other companies or service their debts? Worse still, do they give intercorporate loans? A lot of red flags can emerge here.

Watch out for “early warning alert" signals—how are the bond yields and equity prices moving? What is the bid offer spreads? Are there sudden management/board changes? Are the auditors reputed? For listed companies, the quarterly analyst calls are not only useful to assess developments, but there is benefit from the collective wisdom of many analysts.

We understand that investors want safety and returns when they invest in debt—the measurement of risk is hence key. There are a couple of aspects that are accepted market practice, which we would like to point the pitfalls of.

One is a AAA rating obsession. Investors should not rely on a rating, but use the inputs to arrive at a judgement. The other is yield to maturity, commonly called YTM. Higher the YTM, the better a mutual fund sells, even though there can be liquidity or duration (not necessarily credit) traps.

It often seems to us that we all yield to immaturity while chasing returns and it is important that investors and intermediaries appraise the fund’s processes, consistency of approach and guard rails in the context of your risk appetite.

Our credit team’s WhatsApp group is called Better Safe than Sorry. Very true for the pandemic times, and more so always for investing in credits.

Vivek Ramakrishnan is head - credit risk, DSP Investment Managers.