Dynamic Properties of Earnings in the Bond Market

Abstract

This study extends recent accounting research in the corporate debt market by incorporating a dynamic element into investment decision frameworks that is linked to the recent financial crisis. Controlling for the presence of systematic risk and private information of credit rating agencies, we provide evidence that accounting accruals and cash flows are not associated with corporate bond returns in the three years preceding the financial crisis. However, using a point estimate of the conditional mean of annual bond returns, we find a positive and significant association of accounting accruals with annual bond returns during the recent financial crisis. Additionally, using a semi-parametric technique to include conditional quantiles of bond returns, we show that the rate of change in the regression coefficients is dependent on those quantiles. Thus, we provide evidence that, conditional on the distribution of bond returns, both changes in cash flows and accruals are positively and significantly associated with annual bond returns during the recent financial crisis. Our results suggest that debt market investors base their investment decisions on credible market-based measures during the prefinancial crisis, but complement these information signals with accounting-based measures during the recent financial crisis. Therefore, accounting signals may reflect information about a firm’s closeness to default and creditworthiness that is not captured by market-based measures.