Standard & Poor's Ratings Services is requesting comments on a proposal to update its issue rating criteria for U.S. utility first mortgage bonds as part of our revisions to issue-rating enhancement criteria (see related articles "
Request For Comment: Expanding Recovery Rating Coverage And Enhancing Issue Ratings" published Oct. 4, 2006 and "
Recovery Analytics Update: Expanding Recovery Rating Coverage And Enhancing Issue Ratings" published April 10, 2007 and table 1 below).
Proposal Summary
The update involves minor changes to the approach that we have taken since 2004. The key changes in our proposed U.S. utility issue-rating criteria is that there is now less discretion as to the number of notches that an instrument with a recovery rating of '1' or '1+' will get above the corporate credit rating (CCR) for a given rating category, and that the threshold for receiving a '1+' recovery rating has been reduced. We believe that this will simplify and add to the transparency of the rating process for first mortgage bonds, reducing the potential for inconsistencies.
Table 1
Proposed Revised Recovery Ratings, Ranges, And Issue Ratings For Speculative-Grade Issuers
Recovery rating
Description of recovery*
Recovery range
Issue rating¶
1+
Highest expectation of full recovery
100%
+3 notches
1
Strong expectation of full recovery
90-100%
+2 notches
2
Substantial recovery
70%-90%
+1 notch
3
Meaningful recovery
50%-70%
0 notches
4
Average recovery
30%-50%
0 notches
5
Modest recovery
10%-30%
-1 notch
6
Negligible recovery
0%-10%
-2 notches
*Recovery of principal plus accrued and unpaid interest at the point of default. ¶Indicates issue rating "notches" relative to Standard & Poor's corporate credit rating.
Ratings Impact
Evolution of first mortgage bond criteria for U.S. utilities
Before 1997, a utility's first mortgage bond rating was simply equal to the CCR. In 1997, Standard & Poor's incorporated a more rigorous analysis of ultimate recovery potential to supplement the analysis of default risk for first mortgage bonds. The incorporation of ultimate recovery is particularly important for electric, gas, and water utility first mortgage bond ratings. If, in our analytical conclusion, full recovery of principal can be anticipated in a post-default scenario, an issue's rating may be higher than the CCR or default rating.
In 2004, driven by industry developments, Standard & Poor's revised the method used to determine collateral value. Previously, we attempted to assess different values for types of assets and attributed higher collateral value to the electric, gas, and water delivery assets than to production assets. Production assets were given varying degrees of credit based on relative efficiency (for nonnuclear generating plants), while nuclear assets were given no credit because of their perceived low value in a utility bankruptcy and liquidation. However, because of the industry's structure and the relatively few U.S. utility bankruptcies have not ended in liquidation, we view the potential for liquidation as low. Therefore, in 2004 we changed our criteria such that we do not assign greater values for regulated delivery assets or lower values for regulated generation assets, unless extenuating circumstances warrant a valuation adjustment.
At the same time, we assigned recovery ratings to all utility first mortgage bonds. First mortgage bonds have a strong record of investor protection because the underlying assets that secure them have not been subject to liquidation in bankruptcy and the bonds have almost never defaulted, even when a company is in bankruptcy. The recovery ratings assigned to first mortgage bonds reflect this strong record, with every first mortgage bond assigned one of the two highest recovery ratings of either '1+' or '1'.
Updated first mortgage bond rating methodology
Performance history.
Over the past 50 years, no U.S. utility bankruptcy has ended in liquidation, and Standard & Poor's believes that the likelihood of liquidation in any future utility bankruptcy proceeding is remote. In all bankruptcy cases except one, the utility remained current on its first mortgage bond debt service payments. The one exception was the recent bankruptcy of Entergy New Orleans Inc. Following Hurricane Katrina, the company faced huge rebuilding costs and an extraordinary loss of revenue, and filed for bankruptcy on Sept. 23, 2005. First mortgage bondholders waived interest payments, and the company did not make payments for one year. According to parent Entergy Corp.'s 2006 10-K, Entergy New Orleans' reorganization plan proposes that pursuant to an agreement with the first mortgage bondholders the bonds remain outstanding under their current maturity dates and interest terms. The reorganization plan also proposes to pay first mortgage bondholders an amount equal to the one year of interest that the bondholders had waived when the bankruptcy was pending. With bankruptcy court approval, Entergy New Orleans has begun paying interest accruing after Sept. 23, 2006 on its first mortgage bonds. The Unsecured Creditor's Committee plan does not differ with respect to the first mortgage bonds. Therefore, we expect that the company's first mortgage bond holders will not lose any principal or interest (at least on a nominal basis). Table 2 outlines past utility bankruptcies.
Table 2
Bankruptcies Of Utilities With First Mortgage Bonds
Company
Year filed
Year emerged
Paid first mortgage bond coupons?
Entergy New Orleans Inc.
2005
Pending
No*
NorthWestern Corp.
2003
2004
Yes
Pacific Gas & Electric Co.
2001
2004
Yes
El Paso Electric Co.
1992
1996
Yes
Public Service Co. of New Hampshire
1988
1991
Yes
*Ceased payment for one year, but has resumed while still in bankruptcy.
We continue to believe that the single most important factor in determining a utility's asset value when it emerges from bankruptcy is the revenue stream that regulators allow it to collect. Even in bankruptcy, regulators tend to set rates high enough for the utility to recover prudently incurred fixed and operating costs. As a result, there is a very high correlation between rate base and the assets' book value. Therefore, absent extraordinary extenuating circumstances, such as the market's inability to support prices based on the asset base, Standard & Poor's will assume that the assets' book value represents fair value for the assets. Importantly, the few utility bankruptcies since the 1930s have not resulted in any material asset write-downs.
Assigning the recovery rating.
First mortgage bondholders benefit from a first-priority lien on substantially all of the utility's property and franchises owned or thereafter acquired. The first mortgage bond indenture typically includes as collateral the entire physical plant of a utility, including electric generation, electric and gas transmission and distribution, and water distribution assets, as well as construction work in process. Because of their essential nature, utility asset values are largely independent of the owner's financial condition. In addition to the asset protection, the mortgage indenture typically contains fairly restrictive covenants, including a limitation on the issuance of additional secured bonds based on interest coverage and debt-to-asset tests.
The recovery rating on a utility's first mortgage bond is based on the estimate of collateral value relative to the maximum amount of first mortgage bonds that may be outstanding at any time under the indenture's terms. We use the allowable issuance as opposed to the actual outstanding bonds because most U.S. utilities are rated investment grade, and we would expect that an investment-grade entity's capital structure would change on a path to bankruptcy. Standard & Poor's will also consider other legally binding limitation on the issuance of first mortgage bonds, as well as the actual outstanding first mortgage bonds if circumstances merit. Recovery for creditors is a function of the value of their collateral and priority of position. Therefore, determining the collateral value provides a basis for how well creditors are secured. The analysis does not attempt specifically to predict the ultimate outcome of any bankruptcy proceeding. Rather, our recovery estimate compares the level of collateral to the potential amount of secured debt. Higher collateral coverage levels increase confidence that asset values will cover the secured debt.
Currently, all U.S. utility first mortgage bonds carry a '1' or '1+' recovery rating. In general, if collateral coverage as calculated based on the maximum potential issuance of first mortgage bonds is greater than approximately 2x, Standard & Poor's assigned a recovery rating of '1+'. If collateral coverage is less than approximately 2x, Standard & Poor's assigned a recovery rating of '1'. We also considered collateral coverage based on actual first mortgage bonds outstanding in cases where the collateral coverage is close to 2x. Standard & Poor's proposes to change the threshold for a '1+' to collateral coverage to 1.5x, and while we expect that all first mortgage bonds will carry '1' or '1+' recovery ratings, we may deviate from this practice for speculative-grade issuers where we conclude that expected recovery is less than 100%.
Rating the issue above the CCR.
As ratings improve (i.e., default probability decreases), recovery becomes less relevant to the issue rating. For example, since expected loss is equal to default probability multiplied by loss given default, which yields very low default probabilities (e.g., 2% for a 10-year default probability), there is increasingly little relevance for recovery analysis. However, recovery does become much more relevant as default probability increases to 10% or 20%. Therefore, as default ratings strengthen, the amount of issue-specific ratings separation due to strong recovery prospects decreases. For an 'A' category issuer, we will not enhance the rating of a first mortgage bond by more than one notch above the CCR. However, first mortgage bonds of speculative-grade issuers with very good recovery prospects and strong structural provisions in the bond indentures may be rated up to a full rating category (three notches) above the CCR.
Standard & Poor's proposes guidelines for ratings on utility first mortgage bonds above the CCR (see table 3). As mentioned above, higher rated companies have such a remote likelihood of default that the hurdle for justifying any issue ratings above the CCR is higher than that for companies in the lower investment-grade or speculative-grade categories. If we determine based on our analysis that recovery prospects on first mortgage bonds for a speculative-grade issuer are expected to be less than 90% (i.e., the recovery rating is not '1' or '1+'), we will follow the issue rating guidelines outlined in table 1.
Table 3
Proposed Issue Rating Criteria For U.S. Utility First Mortgage Bonds
Assets/potential secured debt (x)
>1.5
<1.5
Recovery rating
1+
1
Notches above corporate credit rating
'AA' category and higher
0 notches
0 notches
'A' category
+1 notch
0 notches
'BBB' category
+2 notches
+1 notch
Speculative grade
+3 notches
+2 notches
Response Deadline
Please submit your comments on any aspect of this proposal through June 29, 2007 to criteriacomments@standardandpoors.com or by contacting any of the individuals listed at the top of this article.
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