Thread by @Sanjay__Bakshi

I read this extract in the recent circular (bit.ly/2WJXkg9)by @SEBI_India on "Guidelines for Enhanced Disclosures by Credit Rating Agencies (CRAs)"

Requiring CRA's to track devisions in BOND spreads is a good idea. This idea, which really an acknowledgement that the BOND market may know more than the rating analysts is a good idea.

That idea can be made even better. How?

By requiring rating analysts to seek signals from the STOCK market too.

Why, you may ask, should the creditworthiness of a business be influenced by fluctuations in its stock market valuations?

According to Ben Graham, it's a very sound idea. He writes:

"Strenuous objections may, of course, be levelled against using the market price of stock issues as a proof of anything, in view of the extreme and senseless variations to which stock quotations are notoriously subject."

"Nevertheless, with all its imperfections, the market value of the stock issues is generally recognized as a better index of the fair going value of a business than is afforded by the balance-sheet figures or even the ordinary appraisal."

"A low stock equity not only indicates a quantitative deficiency of the issue; it usually implies qualitative inferiority as well and at times casts doubts upon the accuracy of reported earnings."

Ponder on those last few words:

"AND AT TIMES CAST DOUBT UPON THE ACCURACY OF REPORTED EARNINGS"

Graham was a very wise man. While he made all of his money by exploiting INEFFICIENCIES in bond and stock markets, he was wise enough and humble enough to recognize that sometimes markets know more than the analyst.

And he explicitly required his students learning how to conservatively invest in bonds to study the stock price fluctuations in the companies whose bonds were being studied.

I have always felt this to be a very powerful ideas and in my classes I cite to my students, example after example of Indian situations where the stock price decline PRECEDED downgrades from rating companies. And in the last two years, there have been so many more such examples.

I won't cite examples here. You know them.

Time after time, we have seen that stock market almost always knows that there is something wrong in the company well before the CRAs downgrade its debt instruments.

By bringing down the EQUITY market valuation of the company, the STOCK market is, in effect, warning the BOND holders to watch out! It's telling them that either the earnings are going to collapse or the they are fudged.

Now, it's true that stock market will either be right or wrong in its judgement. However, and this is the key point, the BOND analyst cannot be in a position to IGNORE the stock price crash. He cannot the ignore the signal from the stock market EVEN IF THE SIGNAL MAY BE WRONG

A central part of Graham's very sound framework of credit analysis, is a study the relationship between of the stock market valuation of the borrower and its debt, and the fluctuation in that relationship over time.

The job of CRAs is to determine the probability of default. And the probability of default in BONDS is not independent of the STOCK market valuation of the borrower, says Graham.

Why not require CRAs to include this factor in their analysis and disclosures?

One way to do this will be to specifically require the CRAs to certify that whenever there has been significant equity market cap decline of the borrower, the CRAs has factored that development while forming its rating opinion.

I hope @SEBI_India will look at this seriously.