Do Credit Ratings Reflect Underlying Firm Characteristics? Evidence from the Utility Industry

The recent financial crisis has raised questions regarding the role credit rating agencies play in monitoring the quality of corporate debt. Utility industry deregulation serves as a natural testing ground for evaluating the prudence of rating agencies and their monitoring process. Following deregulation and the Enron scandal, the general opinion among industry professionals is that utilities are being punished by credit rating agencies. Contrary to this popular belief, we find that the utility credit ratings are significantly higher compared to those of other firms, and this significance is more pronounced in the post-deregulation period. We also do not find any evidence that the credit ratings of utilities are more likely to be downgraded (upgraded) following deregulation. Although rating agencies often cite regulatory reasons for placing utilities on negative credit watches, these firms‟ ratings are rarely downgraded after being placed on negative watches. We also find that while firms in other industries adjust their capital structures following rating changes, rating changes have insignificant impact on utilities. Thus, despite the statements often seen in popular press, credit ratings of utilities seem more of a product of interactions between utilities and rating agencies than of firm characteristics. In general, our evidence indicates that credit ratings might not always be reflective of the underlying firm characteristics. * Corresponding author. Both authors are at the Department of Finance and Management Science, School of Business, University of Alberta, Edmonton, AB T6G 2R6. The authors can be reached at [email protected] and [email protected]. We thank the seminar participants at the University of Alberta, Fudan University, and the University of Saskatchewan for helpful comments. All errors are our own.