Rating Agency Responsiveness to Changes in the Economic Environment Facing Electric Utilities

Rao, Ramesh, Moyer, R. Charles, Quarterly Journal of Business and Economics

Rating Agency Responsiveness to Changes in the Economic Environment Facing Electric Utilities

Abstract

This paper tests rating agency responsiveness to changes in the economic environment facing electric utilities. Logistic regression is used to model Standard & Poor's ratings of new preferred stocks for 1969-1972 and 1978-1981. During the unstable period 1978-1981, default risk, earnings quality, regulatory climate, and coverage ratios were primary considerations in the rating process. For the stable period 1969-1972, marketability, prifitability, and coverage ratios were the most significant ratings determinants. These results indicate the preferred stock rating process responds to changes in the business risk facing utilities by focusing on different variables over time.

Introduction

Rating agency responsiveness to the changing environment facing utilities is essential. Ratings that ignore significant macroeconomic and industry changes do not provide investors with the best information. This paper develops a logistic regression model to compare rating agency evaluations of preferred stock between a stable operating period, 1969-1972, and an unstable one, 1978-1981. The results indicate that Standard & Poor's changes the weight it places on key variables to reflect changes in the operating environment of a utility. Preferred stock ratings are used as the basis for the analysis because preferred stock is a significant source of financing for electric utilities (as compared with industrial firms) and there is a paucity of research on the preferred stock rating process and on preferred stock valuation.

Literature Review

Preferred stock ratings are tied closely to bond ratings.(1) Consequently, utility bond rating studies provide a foundation for the analysis of preferred stock ratings. Pinches, Singleton, and Jahankhani [11] find that fixed charge coverage ratios, measures of the regulatory climate, firm size, profitability, growth rate in profitability, and construction expenditure activity are among the most important variables determining utility bond ratings. Bhandari, Soldofsky, and Boe [1] find that the level and trend in fixed charge coverage, debt ratio, and return on assets can predict up to 90 percent of the rating changes for electric utilities. Wingler and Watts [17] find that utility bond rating changes are influenced heavily by the amount of noncash earnings (allowance for funds used during construction (AFUDC)).

Research dealing directly with the rating and valuation of preferred stock provides additional insights useful in evaluating the responsiveness of rating agencies to a changing economic environment facing electric utilities. Emanuel [5] develops an option-hedging model for the valuation of preferred stock that supports the importance of coverage ratios and debt ratios in the valuation of preferred stock. Zumwalt [18] uses principal components analysis and multiple discriminant analysis on a large set of financial variables to examine their ability to classify a sample of preferred stocks into their respective Standard & Poor's (S & P) rating categories. He finds that the best classification factors changed significantly over the three years of his study period. The observed lack of stability of the factor parameters in the Zumwalt study suggests that the rating process is a dynamic one. Related research dealing with the valuation of preferred stocks also suggests that investors and rating agencies may focus on different variables over time. Sorenson and Hawkins (SH) [13] find a significant clientele effect associated with preferred stocks bearing sinking funds, resulting in valuation differences over time. Gombola, Kahl, and Nunn [8] question the findings of SH and argue that the shift in returns between sinking fund and nonsinking fund preferred stock can be attributed best to shifts in Federal Reserve Board monetary policy.

In summary, prior work on bond and preferred stock ratings suggests that over time, rating agencies focus on and may place different weights on the set of factors considered to be important in determining the ratings of fixed income securities. This paper tests the proposition that rating agencies emphasize different factors over time, depending on the economic environment. Evidence is found that supports this proposition.

Methodology

The ordered logistic regression model is utilized to classify a sample of preferred stocks into their respective S&P assigned ratings.(2) The logistic regression model estimates weights of the logit function in order to maximize the likelihood of predicting the outcome of events, given a set of independent variables. In the current study, the logistic model indicates the probability of a given preferred stock belonging to the next higher …

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Publication information: Article title: Rating Agency Responsiveness to Changes in the Economic Environment Facing Electric Utilities. Contributors: Rao, Ramesh - Author, Moyer, R. Charles - Author. Journal title: Quarterly Journal of Business and Economics. Volume: 29. Issue: 1 Publication date: Winter 1990. Page number: 86+. © 1999 University of Nebraska-Lincoln. COPYRIGHT 1990 Gale Group.

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