Ratings Reveal Risk
In an interesting article (Oct. 15, 1994), Professor Brooks Marshall suggests that bond ratings are a poor predictor of equity risk, based on a regression of utility risk measures on measures of utility bond ratings. For utility variables, he used 1) stock beta and 2) risk premiums based on analysts' expected forecasts. For bond rating measures, he used 1) average yields for various classes of bonds and 2) a numerical ranking. I suggest that Professor Marshall's measures are misspecified, causing him to understate the strength of the bond rating/equity risk relationship.
With the recent demise of the capital-asset pricing model (see Journal of Investing, Fall 1994, p. 10), investment professionals no longer consider beta a reasonable measure of total equity risk. Value Line, for example, prefers its Safety Rank measure. Interestingly, there is no statistically significant relationship between beta and Safety Rank for utility stocks. Therefore, testing the degree to which bond ratings explain variation in beta tells us little about bond ratings' ability to explain total equity risk.
Is Professor Marshall's risk premium a reasonable measure of equity risk? Unfortunately, the answer here is also no. Investment professionals and financial academics find risk premium calculations, especially those based on analysts' forecasts, of questionable reliability (see Forbes, Oct. 10, 1994, p. 154). Again, Value Line's Safety Rank is a far superior measure.