Criteria – Complexity Level of Rated Instruments/Facilities
The level of complexity of a debt instrument and/or a debt facility plays a very pivotal role for the various associated parties like, investor/lender, market intermediary and regulatory bodies. It is important for the investor/lender to rightly understand & evaluate the terms & conditions and covenants of each debt instrument/facility, more particularly for innovative ones before deciding on any financial exposure, given the series of developments taken place in the financial market. It may not necessarily be perceived that a debt instrument and/or a debt facility with relatively more complexities has more credit risks; however, all associated parties need to know the level of complexities to take the appropriate call. It may so happen that a simple type of debt instrument/facility may have higher credit risk vis-a- vis the complex one. Keeping the aforesaid in view, Infomerics has classified debt instrument/facility based on complexity to facilitate the investor/lender to take the most informed decision. Infomerics believes that this classification will help the intermediaries to identify the right investor, based on level of complexity. This will also enable all the concerned regulatory bodies to guide the major investors in debt instruments (like insurance companies, provident funds, pension funds, etc.).
For this classification, Infomerics has considered four parameters such as, Premature Redemption, Number of Parties Involved in the Transaction, Certainty of Return and Familiarity of Financial Market with the Debt Instrument/Facility. The aforesaid parameters are elaborated below:
(i) Premature Redemption
Usual debt instruments generally do not have any options and hence, there is no reinvestment risk. But certain bonds/debentures, being in the deep discounting nature, have multiple put/call options. Investors for such instruments should be aware of the same so that they should be prepared for the event of issuer exercising the call option and the consequential reinvestment risk.
(ii) Number of Counterparties Involved in the Transaction
Number of counter- parties involved in a transaction is very important as that has a bearing in understanding/evaluating debt instrument/facility. If the debt instrument/facility is guaranteed, then there is a need to understand the implication of creditworthiness of the guarantor as well, besides the issuer/borrower. The guarantor may be one or more and the nature of guarantee may be full or partial and may be conditional/unconditional.
(iii) Certainty of Return
In case of debt instrument/facility carrying fixed interest rate, there is adequate certainty of receiving the interest on due date. This is so in case of fixed deposits, vanilla type of debentures and fixed rate of loans. However, in case of floating rate paper/debt facility, scenario is different. The rate becomes floating when it is linked to some benchmark rate. Hence, the investor/lender should be fully conversant with the nature of interest rate.
(iv) Familiarity of Financial Market with the Debt Instrument/Facility
The financial market needs to be familiar with the debt instrument per se. Certain debt instruments like non-convertible debentures, fixed deposits, commercial paper are, by and large, known to the market. However, with the gradual developments taken place in the market over the years, there are many sophisticated instruments have come in. Those are Pass Through Certificate (PTC), Perpetual Bond, etc. It is therefore necessary for the investors to
become familiar with the pros and cons of such debt instruments.
Based on the above parameters, to the extent applicable, debt instruments/facilities have been classified in three categories: (a) Simple, (ii) Complex and (iii) Highly Complex.
(a) Debt instruments/facilities are classified as Simple when the same carries a fixed rate of interest, there is a pre-specified tenure, there is one counterparty and there is no prepayment risk. Generally, the market is quite conversant with this type of instrument/facility.
(b) Debt instruments/facilities are classified as Complex when the same carries a floating rate of interest, there is a prepayment risk, tenure may be pre-specified but subject to conditions and the number of counterparties may be more than one. The market may be conversant with this type of debt instrument/facility to a limited extent.
(c) Debt instruments/facilities are classified as Highly Complex when the same carries a floating rate of interest, the maturity profile is varied, there is a prepayment risk and the number of counterparties is more than one. Market is generally not conversant with this type of instrument.
Benefits of Classification
For investor/lender – The aforesaid classification is likely to help the investor/lender to understand the nature of instrument/facility and the level of complexities of the structure.
For Intermediaries - This classification is expected to enable the intermediaries to identify the right investor & target accordingly, based on the level of complexity.
For Regulatory Bodies - This classification may help all the concerned regulatory bodies to prescribe investment criteria for the major investors (like insurance companies, provident funds, pension funds, etc.).