Complexity Level of Rated Instruments

Complexity Level of Rated Instruments

Developments in the financial markets have focused attention on the need to have proper understanding of the terms of financial instruments, before selecting them for investment. Even sophisticated investors, in both domestic as well as international markets, may be wary about investing in an instrument without fully comprehending the risks involved. Rapid developments in financial markets aided by technology, requires an investor to have proper understanding of features of instruments, especially the more sophisticated ones, before investing in them. To aid this process, CARE has, as an investor education measure, introduced classification of instruments based on complexity. It is expected that this would enable the investor to take a well-informed decision about investment in a financial instrument. This classification is expected to help the market intermediaries to target investors depending on the levels of acceptable complexity. Further, Government/Regulators would find this classification useful in prescribing the levels of complexity for investment by certain class of investors such as provident funds, trusts, insurance companies etc.

Instruments have been classified into the three categories- simple, complex and highly complex - based on four criteria:

Certainty Of Rate Of Return

In case of traditional fixed deposits and non-convertible debentures with fixed coupon payment, there is no uncertainty regarding the rate of interest on due dates unlike some other instruments which may be linked to a benchmark – say MIBOR.

Premature Redemption

While plain vanilla non-convertible debentures and bonds may not have the put/call option that exposes an investor to reinvestment risk, Deep Discount Bonds generally have multiple put/call options. Investors in such instruments need to be sensitized that their intention to lock in at a preferred rate of interest for the maturity period of the instrument may not fructify if the issuer exercises the call option.

Number of Parties Involved In The Transaction

In case of instruments carrying a guarantee, the investor needs to understand that the credit risk of these instruments is dependent on the creditworthiness of the guarantor apart from the issuer itself. Instruments with partial guarantee are also in vogue, and are more complex in nature.

Familiarity Of Capital Market With The Instrument

While traditional fixed deposits, non-convertible debentures, bonds etc have been popular with investors for decades, Instruments issued by banks for augmenting their capital like perpetual bonds, require an understanding of the regulatory framework and the performance of the issuing bank. All investor classes are also not well acquainted with the intricacies of instruments issued in case of securitization transactions. As the market becomes more sophisticated and market participants become familiar with some instruments, classification based on this criterion may require a revision.

Classification

Classification of instruments based on the above criteria is given below

Simple

Instruments included in this level are the least complex instruments. These are generally, instruments with a fixed rate of return with a pre-determined repayment period. They do not have any prepayment risk and there is only one counterparty. Capital market participants are very familiar with the instrument.

Complex

Instruments included in this level are moderately complex instruments. These are generally, instruments with a variable rate of return. While the repayment period may be fixed, there is a risk of prepayment and number of counterparties may be more than one. Capital market participants may be only moderately familiar with the instrument.

Highly Complex

Instruments included in this level are most complex instruments. They generally have a variable return and maturity profile. Number of counterparties involved may be more than one. Capital market participants are not very familiar with the instrument.

Complexity vs Credit Risk

Classification of instruments based on complexity should not be misconstrued as an indicator of inherent credit risk of the instrument. Even instruments classified as Simple may have a higher credit risk compared to those classified as Complex or Highly Complex. For example, while Fixed Deposits, which are unsecured in nature, are simple instruments to transact, the credit risk may be higher (in case of a weaker entity issuing the deposit) than that of Highly Complex instrument like Asset Backed Securities.

Benefits

It is expected that the above classification would be useful to investors and market intermediaries. The investors would find the classification useful to understand the degree of due diligence required before selecting an instrument. Market intermediaries would find it useful in targeting different classes of investors with instruments of acceptable levels of complexity. Further, it is also expected that the Government/regulators would find the classification useful while stipulating investment criteria for certain classes of investors like provident funds, trusts, insurance companies etc. For classification of instruments based on the criteria mentioned above please refer to annexure.

This service is being made on a voluntary basis, free of cost as an investor education measure.

Investors are also free to contact at care@careratings.com to obtain classification of instruments based on complexity.

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