How Does the Corporate Bond Market Value Capital Investments and Accruals?

Transcription

1 How Does he Corporae Bond Marke Value Capial Invesmens and Accruals? Sanjeev Bhojraj Bhaskaran Swaminahan * Forhcoming in he Review of Accouning Sudies Final Draf: June 2007 * Bhojraj is Assisan Professor of Accouning and Swaminahan is Parner and Direcor, Research a LSV Asse Managemen, Chicago, IL for Sanjeev Bhojraj: sb235@cornell.edu and Bhaskaran Swaminahan: swami@lsvasse.com. We hank David Brown, Joel Demski, Paul Hribar, Charles Lee, Sco Richardson, Jay Rier, Richard Sloan and workshop paricipans a Cornell Universiy, Universiy of Florida, Universiy of Illinois, Universiy of Michigan, Prudenial Equiy Group s 18h Annual Quaniaive Research Conference, QRG Quaniaive Equiy Conference, he Journal of Accouning Research Conference and especially an anonymous referee for helpful commens.

2 How Does he Corporae Bond Marke Value Capial Invesmens and Accruals? Absrac This paper examines wheher he mispricing of accruals documened in equiy markes exends o bond markes. The paper finds ha corporae bonds of firms wih high operaing accruals underperform corporae bonds of firms wih low operaing accruals. In he firs year afer porfolio formaion, he underperformance is 115 basis poins using an accrual measure ha includes capial invesmens and 93 basis poins using an accrual measure ha is based only on working capial invesmens. The Sharpe raios of he zero-invesmen bond accrual porfolios are comparable o hose of he corresponding zero-invesmen sock accrual porfolios. The resuls are also robus o risk adjusmens based on boh a facor model consising of he Fama and French (1993) sock and bond marke facors and a characerisics model based on bond raings and duraion. Cross-secional Fama-MacBeh regressions ha use individual bond daa and conrol for sock and bond issuances in addiion o raings and duraion also confirm he ime-series porfolio findings. Overall, our resuls reveal an accrual anomaly among bonds similar o ha observed among socks.

3 1. Inroducion Recen research has uncovered an anomaly relaed o operaing accruals, 1 defined as he difference beween earnings and cash flows (see Sloan (1996)). 2 Socks wih high operaing accruals end o underperform socks wih low operaing accruals, suggesing ha high (low) accrual socks are relaively overvalued (undervalued). The mos popular explanaion for he accrual anomaly is he apparen inabiliy of sock marke paricipans o undersand he relaionship beween accruals and fuure earnings and cash flows. Previous research has shown ha firms wih high curren earnings accompanied by high curren accruals (and herefore low curren cash flows) end o have lower fuure earnings and cash flows han firms wih high curren earnings accompanied by low curren accruals. In oher words, earnings accompanied by higher accruals are supposed o be of lower qualiy han ha accompanied by lower accruals, where he erm qualiy refers o he informaion abou fuure earnings and cash flows. According o his earnings qualiy explanaion, invesors who are unable o disinguish beween low qualiy and high qualiy earnings overvalue socks wih high accruals and undervalue socks wih low accruals. 3 Earnings qualiy should also be of concern o corporae bond invesors since deb is serviced ou of cash flows raher han repored earnings. As saed in he Sandard & Poor s (S&P) guide on he mehodology for deermining bond raings, under he heading of cash flow adequacy: Ineres or principal paymens canno be serviced ou of earnings, which is jus an accouning concep; paymen has o be made wih cash. Alhough here is usually a srong relaionship beween cash flow and profiabiliy, many ransacions and accouning enries affec one and no he oher. Analysis of cash flow paerns can reveal a level of deb-servicing capabiliy ha is eiher sronger or weaker han migh be apparen from earnings...cash flow analysis is criical in all credi raing decisions. 1 Depending on how he earnings and cash flows are defined he operaing accruals measure migh include only working capial accruals or boh working capial accruals and capial invesmens. We discuss his in deail in Secion 2. 2 Papers exending Sloan (1996) include Thomas and Zhang (2002), Xie (2001), Chan, Chan, Jegadeesh and Lakonishok (2006), Collins, Gong and Hribar (2003), Richardson, Sloan, Soliman, and Tuna (2005), Hirshsleifer, Hou, Teoh, and Zhang (2003), and Fairfield, Whisenan, and Yohn (2003). 3 The earnings qualiy explanaion is usually accompanied by an earnings managemen hypohesis where i is suggesed ha he differences in earnings qualiy is he resul of a deliberae choice on he par of managers who use heir discreion o manage earnings. However, one does no need o assume earnings managemen o explain he source of mispricing. Mispricing which is he resul of invesor unsophisicaion can coexis wih more benign explanaions for he observed differences in earnings qualiy. 1

4 These quoes underscore he imporance of cash flows and earnings qualiy o corporae bond invesors. Ye, exising research has focused exclusively on he sock marke. In his paper, we address his gap by examining how he corporae bond marke values he informaion in operaing accruals. Focusing on he corporae bond marke is also of heoreical ineres since socks and bonds are coningen claims on he same underlying cash flows and firm value (see Black and Scholes (1973) and Meron (1974)) and, herefore, one would expec common informaion o affec he valuaion of boh securiies. The primary issue, however, is wheher he corporae bond marke prices his informaion more efficienly han he sock marke. In our analysis, we consider wo measures of operaing accruals: (a) he radiional accrual measure of Sloan (1996) which we refer o as working capial accruals (WCA), and (b) a new measure suggesed by Richardson, Sloan, Soliman and Tuna (2005) ha includes capial invesmens which we refer o as ne new invesmens (NNI). The NNI measure is closely ied o he reinvesmen rae (or plowback rae) defined in finance exbooks. 4 The reinvesmen rae measures he funds reinvesed in a firm s curren and long-erm operaing asses as a fracion of is operaing profis afer axes. The fracion of operaing profis available afer reinvesmen represens a firm s free cash flows. Thus, he wo operaing accrual measures widely discussed in he accouning lieraure refer o a firm s curren and long-erm capial invesmens ne of replacemen capial invesmens. Our sudy uses a unique daabase on corporae bonds from Lehman Brohers conaining roughly 2,300 corporae bonds corresponding o abou 540 firms each year from 1973 o To be included in any monh in our sample, each firm mus have a leas one non-converible bond available wih hree or more years o mauriy and be raed by Moody s or S&P. We also use addiional daa filers (discussed in he daa secion) o eliminae bonds wih any poenial pricing errors. As a resul of hese requiremens, he firms in our sample end o be relaively larger han hose in exising accrual sudies (see panel C of Table 1). Therefore, our findings on he accrual effec in equiies and bonds should be considered a lower bound of he full sample accrual effec. On he oher hand, our resuls migh also consiue wha may be, in fac, achievable for an insiuional invesor ne of ransacion coss since insiuions ypically avoid smaller firms. 2

5 Our key findings are as follows. Bonds of firms wih high accruals significanly underperform bonds of firms wih low accruals. In he firs year afer he porfolio formaion dae, for he overall sample period of 1973 o 1997, he underperformance is a saisically significan 115 basis poins using he ne new invesmen accruals (NNI) measure and 93 basis poins using he working capial accrual measure (WCA). In general, he underperformance coninues up o Year 3, weakening gradually from Year 1. The Sharpe raios corresponding o he zero-invesmen bond accrual porfolio (long high accrual and shor low accrual) are comparable in magniude o he Sharpe raios corresponding o he zero-invesmen sock porfolio, suggesing ha he resuls are also economically significan. The underperformance is weaker bu saisically and economically significan in sub-samples (chosen o minimize concerns abou illiquidiy) ha exclude bonds wih unique feaures (callable, puable, secured, annual coupons, sinking fund provisions, ec.), bonds no in he Lehman bond indices and include only he mos recenly issued bond as of he porfolio formaion dae. This suggess some of he underperformance may be driven away by ransacion coss. The underperformance is also robus o facor risk adjusmens based on a 6-facor model consising of a defaul facor, a erm risk facor, he hree Fama and French (1993) sock marke facors and he reurn on he corresponding zero-invesmen sock accrual porfolio (we use his variable o conrol for he accrual effec in sock reurns and conemporaneous correlaion beween sock and bond reurns of he same firm) and characerisic risk adjusmens based on duraion and bond raings. Cross-secional Fama-MacBeh regressions ha use individual bond daa and conrol for sock and bond issuances in addiion o raings and duraion also confirm he ime-series porfolio findings. We conrol for equiy and bond issuances o rule ou he possibiliy ha he underperformance in bond reurns migh be driven by any underperformance following deb and equiy offerings. Overall, our resuls show ha he corporae bond marke misprices accruals in he same manner as he sock marke. Thus, no only are he socks of firms wih high accruals overvalued bu also heir bonds, which sugges ha ha he enire firm wih high accruals is overvalued. In oher words, he overvaluaion of high accrual firms canno be explained by wealh redisribuion beween equiy and deb. Furhermore, he fac ha he overvaluaion resul becomes sronger 4 See Copeland, Koller, and Murrin (2000). 3

6 when using ne new invesmen accruals (NNI) indicaes ha he sock and he bond marke paricularly overvalue firms wih high capial expendiures. Wha are he implicaions of our findings for he earnings qualiy explanaion? Our resuls sugges ha corporae bond invesors are unable o disinguish beween low earnings qualiy and high earnings qualiy in he same manner as sock invesors. I is puzzling as o why corporae bond invesors who have srong incenives o focus on cash flows and who end o be large, sophisicaed insiuional invesors, are deceived by differences in earnings qualiy in he same manner as equiy invesors. Perhaps he informaion in accruals has o do wih more han jus earnings qualiy and is relaed o over-opimism abou he value creaed by curren capial expendiures. This is an imporan avenue for fuure research. Our resuls are also paricularly ineresing in ligh of he fac ha payoffs from deb are less volaile han equiy payoffs. The value of deb should be less sensiive o changes in he underlying cash flow as compared o he value of equiy. Therefore, i should be more difficul o deec mispricing in he bond marke compared o equiy. The evidence ha he accrual effec exends o bond markes is indicaive of he robusness of he mispricing associaed wih accruals. From an invesmen perspecive, our resuls sugges ha here is more han one marke venue for invesors o exploi he accrual effec. The res of he paper proceeds as follows. Secion 2 discusses he wo accrual measures used in his sudy and relaes hem o operaing profis, free cash flows, and he reinvesmen rae. Secion 3 describes he daa used in he sudy, Secion 4 provides he empirical resuls and Secion 5 concludes he paper. 2. Operaing Profis, Free Cash Flows, Ne New Invesmens, and Accruals As discussed earlier, we use wo measures of operaing accruals. One is he original accrual measure recommended by Sloan (1996), defined as he change in non-cash working capial less depreciaion, i.e., working capial accruals (WCA). The oher measure is based on recen work exending he definiion of accruals o include changes in non-curren operaing asses (Fairfield, Whisenan and Yohn (2003); Hirshleifer, Hou, Teoh and Zhang (2004); Richardson, Sloan, Soliman and Tuna (2005)). 5 These sudies find ha he mispricing of accruals by he sock 5 Richardson e al. (2005), formally derive a comprehensive measure of accruals by defining i as he difference beween accrual earnings and cash earnings. The basic argumen is ha in he absence of accrual accouning he only 4

7 marke is no limied o WCA, bu exends o non-curren operaing accruals. Non-curren operaing asses, which represen accruals relaing o invesing aciviies, usually involve expendiures relaed o purchase of propery, plan and equipmen, business acquisiions and developmen coss. Richardson e al., (2005), sugges ha he ulimae cash flow sream associaed wih hese asses is uncerain and herefore he iniial recogniion and reversal of hese accruals are subjecive. Consisen wih hese sudies, we define our second measure of accruals o include boh working capial and non-curren operaing asses (ne new invesmen accruals (NNI)). These wo accrual measures are closely relaed o he reinvesmen rae defined in he finance exbooks. Below, we formally define hese wo measures and clarify heir relaionship o he reinvesmen rae. 2.1 Ne New Invesmen Accruals (NNI) To undersand he relaionship beween earnings, free cash flows, ne new invesmens and accruals; le us sar wih he exbook definiion of he free operaing cash flows of he firm (FCFF) generaed by he ne operaing asses of he firm: FCFF( = NOPAT ( + Dep( ΔWC( CapEx( (1) NOPAT( = Ne operaing profis afer axes for year. Dep( = Depreciaion & Amorizaion expenses for year. ΔWC( = Change in operaing working capial for year ; operaing curren asses include receivables and invenories and exclude cash and shor-erm invesmens and operaing curren liabiliies include accouns payable and accrued expenses and exclude noes payable and oher ineres-bearing curren liabiliies. CapEx( = Capial expendiures and acquisiions excluding long-erm invesmens in reasury & corporae bonds and equiies of unrelaed subsidiaries. asse or liabiliy on he balance shee would be cash. Thus everyhing else on he balance shee is accruals. This measure of accruals differs from he radiional definiion in ha i includes non-curren asses and non-curren liabiliies. 5

8 Now, define gross invesmen (GI) as he sum of working capial and long-erm operaing invesmens: GI( = CapEx( + ΔWC( (2) The ne new invesmen (NI) underaken by he firm is he gross invesmen less he replacemen invesmen. A firm needs replacemen invesmen o mainain he curren profis and cash flows and new invesmens o grow. A proxy for he replacemen invesmen is depreciaion & amorizaion. Therefore, empirically, ne new invesmen may be measured as follows: [ ] 14 CapEx 44 ( ΔWC 44 ( 3 12 Dep 3 ( ) NI( = (3) Gross Invesmen Replacemen Invesmen Combining equaion (1) wih equaion (3), we can rewrie free cash flows (FCFF) as: FCFF( = NOPAT ( NI( (4) Thus, economically free cash flow is he residual cash lef over from operaing profis afer a firm has reinvesed a fracion of is profis back in he firm. Define reinvesmen rae (b) as he raio of ne new invesmens o operaing profis afer axes: NI( b ( = (5) NOPAT ( Now, define invesed capial (IC) (same as ne operaing asses, NOA) as he sum of ne operaing working capial (WC) and ne fixed and long-erm operaing capial (FC): IC ( = WC( + FC( (6) By definiion, he change in invesed capial equals ne new invesmens: NI( = IC( IC( 1) (7) 6

9 Muliply (b) in equaion (5) by he reurn on invesed capial ROIC( (defined as he raio of NOPAT( o IC(-1)) and refer o he resuling quaniy as he ne new invesmen accrual NNI(: NNI( = b( ROIC( NI( NOPAT ( = NOPAT ( IC( 1) NI( = IC( 1) IC( IC( 1) = IC( 1) (8) Thus, he produc of reinvesmen rae (b) and he reurn on invesed capial (ROIC) gives he oal accrual measure suggesed by Richardson, Sloan, Soliman, and Tuna (2005) which is jus he growh in invesed capial (IC). 6 Equaion (8) shows ha his measure is influenced by a firm s capial expendiure policy as well as is profiabiliy capured by he reurn on capial. 2.2 Working Capial Accruals (WCA) Now drop CapEx from he definiion for ne new invesmen (NI) in equaion (3) and define a new quaniy referred o as he ne working capial invesmen (WCI): WCI( = ΔWC( Dep( (9) If we divide WCI by NOPAT we ge working capial reinvesmen rae (bw): WCI( bw ( = (10) NOPAT ( 6 Fairfield, Whisenan, and Yohn (2003) define a similar measure excep hey scale he change in invesed capial or ne operaing asses by oal asses. 7

10 Now muliply (bw) by ROIC and by he raio of las period s IC o oal asses (TA) and refer o he resuling measure as he working capial accrual (WCA): IC( 1) WCA( = bw( ROIC( TA( 1) WCI( NOPAT ( IC( 1) = NOPAT ( IC( 1) TA( 1) WCI( = TA( 1) (11) which gives Sloan (1996) s original accrual variable. Equaion (11) provides insighs as o he consiuens of his variable. I is a produc of he working capial reinvesmen rae, reurn on invesed capial and he raio of invesed capial (ne operaing asses) o oal asses. Equaions (8) and (11) raise he possibiliy ha he link beween accruals and fuure reurns could be caused by overinvesmen on he par of firms or overopimism abou he profiabiliy of new invesmens on he par of invesors, in addiion o oher facors. While we do no aemp o disenangle hese effecs in his paper, he above analysis is sill useful in inerpreing our findings. Prior work sudying he sock reurns of firms subsequen o a deb or equiy offering find ha hese firms end o underperform heir conrol groups (e.g., Loughran and Rier (1995); Spiess and Affleck-Graves (1999)). Given ha working capial and capial expendiures are funded hrough a combinaion of inernal and exernal capial, i is likely ha firms wih large increases in working capial or non-curren operaing asses will use exernal equiy or deb o fund hese invesmens. I is herefore possible ha he effec of accruals on fuure reurns could be caused by he underperformance ha resuls from exernal financing aciviies. Cohen and Lys (2006) and Dechow, Richardson and Sloan (2007) explicily examine he link beween accruals, financing aciviies and reurns and find ha he accrual effec subsumes he financing effec. We conrol for hese effecs in our empirical ess. 3. Daa 8

11 3.1 Corporae Bond Daa The corporae bond daa used in his sudy is drawn from he Lehman Brohers Fixed Income Daabase (LBFI), which covers he period from January 1973 o February The LBFI daabase conains monh-end bid prices, raings, yields, and oher characerisics for housands of publicly raded, non-converible corporae bonds and is currenly he bes corporae bond daabase available for academic sudies. In addiion, acual rader quoes for round los of a leas five hundred bonds, raher han marix prices, make up he majoriy of he bids. Hong and Warga (2000) find ha he bid prices conained in he LBFI daabase correspond closely wih repored ransacions and are beer, in ha hey have significanly fewer price discrepancies from ransacion daa han bid prices for bonds raded on he NYSE s Auomaed Bond Sysem. Lehman Brohers uses he prices in he LBFI daabase o consruc is widely followed corporae bond indices. Since Lehman Brohers also rades hese indices, here are srong incenives in general for accurae prices. However, according o Hie and Warga (1997), Lehman (like oher banks) was no a major player in he high-yield marke before 1992, did no publish high-yield benchmark indices before 1992, and, herefore, he high-yield bonds in he Lehman daabase is dominaed by fallen angels wih fewer original issue bonds. This suggess he possibiliy ha he prices of high-yield bonds before 1992 may no be accurae. We discuss below he various seps we have aken o address his and oher poenial daa issues. In addiion, we have also examined he robusness of all of our key findings in sub-samples chosen o minimize hese concerns (see Secion 4.3). There are oher poenial problems wih he daabase. 7 All bonds have missing daa on Augus 1975 and December In addiion, some bonds have daa missing on oher daes beween he firs dae hey appear in he daabase and he las. Bonds wih daa missing on more han four daes including Augus 1975 and December 1984 are eliminaed from he sample. Perhaps a more severe problem is ha reurns are calculaed from monh-end bid prices of a single marke maker, no ransacion prices. There is he addiional concern ha even he prices of invesmen grade bonds no included in he Lehman bond indices may no be accurae. 8 We address hese concerns as follows. Firs, we exclude non-coupon bonds and shor ime-o-mauriy bonds 7 For a more deailed descripion of he daabase see Hong and Warga (2000). 8 In Secion 4.3, we examine he robusness of our findings in a sub-sample ha eliminaes all bonds no in any Lehman bond index. 9

12 because liquidiy migh be low for hese issues and could herefore subjec hem o pricing errors. 9 Second, o minimize he influence of daa errors in bid prices, we use a rudimenary error filer: if a bond has reurns of greaer han 95% in monh followed by reurns of less han -45% in monh +1 or vice-versa, we drop he firm o which ha bond belongs from our analysis. In oher words, if he price jumps up (down) significanly in one monh and down (up) significanly nex monh so as o offse he previous monh s gain, i is mos likely an error. This filer eliminaes only 24 firms from our analysis. 10 The final bu less easily addressed issue is ha some bonds leave he daabase for unknown reasons i.e., hey canno be direcly classified as maured, called, defauled or sill ousanding. This could poenially inroduce a delising bias ino he resuls depending on wha acually happened o hose bonds and wheher he delising was known ex-ane. However, he percenage of firms, which delis for unknown reasons, averages less han 1% per year. Thus, o be included in our sample in any monh, each bond mus be coupon bearing, have a leas hree years o mauriy and saisfy he error filers discussed above. Finally, o minimize any microsrucure problems in he daa, we leave a one-monh gap beween he porfolio formaion monh and he firs monh we sar compuing he fuure reurns earned by he porfolio. Boh S&P and Moody rae mos issues. We use he mean raing if boh raings are available, and oherwise use he raing ha is available. Raings are convered o an ineger ranking ranging from 0 o 23 wih 0 represening AAA+ and 23 represening CC-. Thus, higher raing numbers represen higher risk and lower qualiy. The monhly corporae bond reurn as of ime +1, r +1, is compued as follows: ( P + AI ) + C ( P + AI ) = (12) P + AI r 9 Elon, Gruber, Agrawal, and Mann (2001) noe ha eliminaing bonds no included in he indices eliminaes all bonds wih mauriy less han a year. We exclude all bonds wih less han hree years o mauriy from our analysis. 10 We have also examined he robusness of our findings by using differen filers: > 100% and < -50%, > 90% and < -40% and he resuls do no appreciably change. 10

13 where P is he quoed price a ime, AI is accrued ineres which is he coupon paymen scaled by he raio of days since he las paymen dae o he days beween las paymen and nex paymen, and C +1 is he semi-annual coupon paymen (if any) a ime +1. Noe ha he sum of quoed price and he accrued ineres give he cash price of he bond. As long as P or P +1 are no missing, we can compue a reurn for monh +1. Since accruals are a firm level concep and a firm could have more han one bond, we calculae he value-weighed bond reurns (using he ousanding amoun of each series of bonds) for each firm. By value-weighing he monhly reurns of all eligible bonds of a firm by he oal marke value of each bond, biases due o bad prices of paricular bonds should be significanly reduced Ne New Invesmen Accruals (NNI) Ne new invesmen accrual (NNI) is measured as he growh in invesed capial (ne operaing asses) as defined in equaion (8). Following Richardson e al (2005), invesed capial is compued from he balance shee as follows: Invesed Capial = Operaing Asses Operaing Liabiliies Operaing Asses = Toal Asses (6) Cash & shor-erm invesmens (1) Operaing Liabiliies = Toal Asses (6) Toal Deb (9 & 34) Book Value Common and Preferred sock (60 & 130) Minoriy Ineres (38) The numbers in parenheses are annual COMPUSTAT iem numbers. 3.3 Working Capial Accruals (WCA) Working capial accruals (WCA) are compued using he Quarerly and Annual COMPUSTAT Primary, Supplemenary and Teriary and Research Files. We esimae quarerly WCA using he cash flow mehod as he difference beween earnings and cash flow from operaions: WCA = (Earnings from coninuing operaions (76) Cash flow from coninuing operaions (108 less 78))/Toal Asses 11 As discussed laer, analysis using he mos recenly issued bond yielded similar resuls. 11

14 The numbers in parenheses are quarerly COMPUSTAT iem numbers. Trailing-four-quarer (TFQ) accruals are calculaed every monh as he sum of he accruals over he las four quarers scaled by oal asses a he beginning of he firs quarer. 12 For observaions ha have missing accruals daa when using he quarerly cash flow mehod, we resor o he quarerly balance shee approach where WCA = [(Change in curren asses Change in cash) (Change in curren liabiliies Change in deb included in curren liabiliies) Depreciaion & Amorizaion]/Toal Asses. In he even quarerly accruals are unavailable, we subsiue TFQ accruals wih fiscal year accruals using annual daa. In using annual daa, we follow he same procedure wherein we firs aemp o deermine accruals using cash flow informaion and if hese are no available, we urn o balance shee daa. To ensure ha he accrual informaion is available publicly as of he porfolio formaion dae, we allow for one monh beween he porfolio formaion dae and he dae on which he TFQ is calculaed. If he las quarer in he TFQ calculaion is he 4 h quarer or if annual daa is used, we allow for a 4 monh gap since i akes longer for 4 h quarer resuls o be released. Panel A of Table 1 provides saisics on he sample of firms ha have boh corporae bond daa and daa on NIA or WCA available and ha saisfy all of our selecion crieria. The number of firms varies from 195 in 1973 o 824 in The number of corporae bonds in he sample varies from 327 in 1973 o 3,108 in Panel B provides average reurn earned by bonds raed AAA/AA, A, BBB, below BBB and an equal-weighed porfolio of all corporae bonds. Panel B also provides he average reurn on long-erm governmen bonds and defaul and erm facors. The defaul facor is defined as he difference in reurns earned by an equal-weighed porfolio of all corporae bonds wih a leas en years o mauriy and long-erm governmen bonds. The expos defaul risk premium is 5 basis poins a monh. The erm facor is defined as he difference beween long-erm governmen bond reurns and one-monh T-bill reurns. The ex-pos erm risk premium is 18 basis poins a monh. The firms in he corporae bond sample ha we use in his paper represen he larger firms in he U.S. sock marke. This is he resul of he fac ha generally only large firms issue public deb 12 In calculaing each quarer s numbers, we adjus for he cumulaive reporing of quarerly daa by Compusa. 12

15 ha are raed by raing agencies and he various oher filers (discussed earlier) we impose on he daa o minimize concerns abou illiquidiy and daa errors. Panel C of Table 1 provides mean and median equiy marke capializaion ranks for he overall corporae bond sample and wo sub-samples requiring he availabiliy of he accrual daa and membership in Lehman indices. The numbers provided in he able are ime-series averages of cross-secional saisics. The median size rank for he overall sample is 8. The median rank remains 8 for he sub-sample requiring availabiliy of accrual daa. The median rank rises o 9 for a sub-sample requiring Lehman membership. These numbers sugges ha he corporae bond sample used in his paper represens he larges firms in he U.S. sock marke. Thus, any mispricing relaed o accruals observed in his sample should represen a lower bound of ha observed in a larger sample. In addiion, i should be noed ha any robusness es performed in he paper o minimize concerns abou illiquidiy involves even larger firms in his already large firm sample. 4. Reurns earned by accrual porfolios 4.1 Sock Reurns The accrual sraegies are implemened as follows. A he beginning of each monh from January 1973 o February 1997, we form quinile porfolios of all available firms based on heir NNI or WCA accrual measures. P1 is he low accrual porfolio consising of firms wih he lowes accruals, P5 is he high accrual porfolio consising of firms wih he highes accruals and P3 is he porfolio wih average accruals. We compue reurns (in percen earned by hese porfolios over he nex four quarers and he subsequen wo years. K=1, 2, 3, or 4 refers o quarers one hrough four. Since he sraegy uses overlapping monhly observaions, he holding period reurns are auocorrelaed up o he degree of he overlap. The quarerly reurns are auocorrelaed up o wo lags and he annual reurns up o eleven lags. Therefore, he asympoic Z-saisics (repored in parenheses) are compued using he Hansen and Hodrick (1980) and Newey and Wes (1987) (henceforh simply Hansen-Hodrick-Newey-Wes auocorrelaion correcion wih he appropriae lags. Table 2 repors he reurns earned by he socks of he firms in he various accrual porfolios. Compuing he sock reurns allows us (a) o examine how he resuls involving our resriced sample of firms compare o hose repored in earlier sudies and (b) o provide a benchmark o compare he profiabiliy of sraegies involving corporae bonds. Panel A presens resuls based 13

16 on ne new invesmen accruals (NNI) and Panel B presens resuls based on working capial accruals (WCA). The resuls show ha he NNI measure performs beer han he WCA measure alhough boh measures generae a saisically and economically significan accrual effec in sock reurns. The resuls show ha socks of he high NNI porfolio underperform socks of he low NNI porfolio by 6.64% during he firs year (Year 1) afer porfolio formaion. The underperformance coninues in Year 2 where i is a significan 3.27%. In comparison, socks of he high WCA porfolio underperform socks of he low WCA porfolio by a saisically significan 3.64% during he firs year afer he porfolio formaion dae. The resuls also show ha during he firs year he underperformance is he sronges in he firs quarer afer he porfolio formaion dae and weaker in subsequen quarers. The magniude of he zero-invesmen profis based on working capial accruals (WCA) is abou 1/3 rd of he findings repored in Sloan (1996) which is based on a larger sample of firms and is similar o he profis in Collins, Gong and Hribar (2003) who limi heir sample o firms wih high insiuional ownership. This is no unexpeced since our sample consiss of firms wih publicly raded bonds ha are followed by raing agencies and are herefore likely o be larger in size, more liquid, and widely followed. The las row of Panels A and B of Table 2 provide he (absolue) Sharpe raios of hese sraegies o give a sense of he risk-reurn radeoff involved in hese sraegies. The Sharpe raio corresponding o he profis of he zero-invesmen sraegy (P5-P1) in Year 1 (based on nonoverlapping calendar year reurns) is 0.71 for sraegies based on NNI and 0.41 for sraegies based on WCA. 13 We will use hese Sharpe raios as benchmarks o evaluae he economic significance of he profiabiliy of sraegies involving corporae bond reurns. 4.2 Corporae Bond Reurns Table 3 provides he key findings of our paper on he relaionship beween operaing accruals and corporae bond reurns. Panel A provides he reurns earned by he ne new invesmen accrual (NNI) porfolios and Panel B provides he reurns earned by he working capial accrual (WCA) porfolios. The resuls reveal a significan accrual effec in corporae bond reurns. The 13 The Sharpe raio is he raio of he average excess reurn divided by he sandard deviaion of excess reurn. 14

17 resuls show ha, in Year 1, he bonds of he high NNI porfolio underperform he bonds of low NNI porfolio by 115 basis poins (Panel A) while he bonds of he high WCA porfolio underperform he bonds of he low WCA porfolio by 93 basis (Panel B). There is significan underperformance in Year 2 also wih 65 basis poins underperformance for he NNI sraegy and 100 basis poins (which is higher han he firs year underperformance) for he WCA sraegy. The higher second year underperformance using WCA is surprising given ha he WCA effec in equiies seems o disappear afer one year. The cumulaive underperformance over he firs wo years is abou 200 basis poins for boh he NNI and he WCA porfolios. Inra-year in Year 1, he underperformance is spread over all four quarers wih he underperformance ranging from 13 o 37 basis poins per quarer for he NNI sraegy and 13 o 24 basis poins for he WCA sraegy. 14 Is underperformance in he range of 93 o 115 basis poins economically significan, especially when compared o numbers in he range of 3.64% o 6.64% for socks? In answering his quesion, i is imporan o noe ha while bonds earn lower reurns han socks, hey are also less volaile. Therefore, we use Sharpe raios o compare profiabiliy across asse classes. The (absolue) Sharpe raios corresponding o he P5-P1 bond porfolio in Year 1 (based on nonoverlapping calendar year reurns) for he NNI sraegy and he WCA sraegy are 0.65 and 0.49, respecively. This is comparable o he range of 0.41 o 0.71 obained for he sock porfolios in Table 2 and suggess ha he accrual effec in corporae bonds is economically significan. The economic significance of he resuls in Table 3 is also relaed o he issue of liquidiy and rading coss in corporae bonds. Hong and Warga (2000) use ransacions daa and esimae he spreads on invesmen grade bonds o be around 13 basis poins for a one way ransacion or 26 basis poins for a round rip ransacion. Since he zero-invesmen bond porfolio reurns are in he range of 93 o 115 basis poins, on paper, he sraegies appear o be profiable even afer aking ino accoun ransacion coss. However, here are wo issues ha migh lead o higher ransacion coss. Firs, our sample also includes non-invesmen grade bonds, which are likely o be less liquid han invesmen grade bonds. Second, he bonds in he exreme accrual porfolios, 14 All of he porfolio analysis is done using equal-weighed reurns. However, we esed he robusness of our resuls using value-weighed porfolios. The resuls (unabulaed) hough slighly weaker coninue o be economically and saisically significan. This is consisen wih our sample consising mainly of large firms. 15

18 which represen he mos mispriced bonds, could be less liquid han bonds in he inermediae porfolios. As a resul, he realizable profis could be a lo less han he paper profis. Overall, he underperformance of he corporae bonds of he high accrual porfolio suggess ha hese bonds were overvalued as of he porfolio formaion dae. On he flip side, corporae bonds of low accrual porfolios rade a a relaive discoun. 4.3 Robusness Tess There are several concerns abou he robusness of he findings in Table 3. Firs, our analysis includes high yield, (non-invesmen grade) bonds bu Lehman (like oher major banks) did no publish high-yield benchmark indices before As we discussed in he daa secion, bonds no on a Lehman index migh conain more daa errors. To address his concern, we excluded non-coupon bonds and bonds wih mauriies less han hree years from our sample. These seps, however, may no be sufficien for non-invesmen grade bonds. Second, even invesmen grade bonds no in any Lehman index may conain daa errors. Third, our analysis also includes bonds wih special feaures such as callabiliy, puabiliy, sinking fund provisions ec. Accouning informaion may be less imporan in he pricing of bonds wih opion feaures, hese bonds may be less liquid, and heir risk benchmarks may be misspecified, all of which could lead o mispricing. I would be of ineres o know wheher he resuls in Table 3 would hold even afer we eliminae hese bonds. Finally, value-weighing individual bond reurns may no compleely eliminae daa errors associaed wih individual bonds. To address hese concerns, we consruc a sub-sample of bonds ha excludes all bonds no in a Lehman index as of he porfolio formaion dae, and hose wih unique feaures (see Duffee (1999) and Elon, Gruber, Agrawal, and Mann (2001)); i.e., i includes only noncallable, nonpuable, senior unsecured sraigh bonds wih semiannual coupons wih no variaion in promised coupon paymens over ime, no sinking fund provisions, original mauriies of less han 35 years and remaining mauriy of a-leas one year. This filer eliminaes more han half of our sample, leaving fewer han en firms per porfolio prior o Therefore, we eliminae he pre daa and focus on he 1987 o 1997 ime period. Because we eliminae all bonds no in he Lehman index a any given ime, his sample conains only invesmen grade bonds in he Lehman index, does no conain any non-invesmen grade bonds prior o 1992, and conains 16

19 only hose non-invesmen grade bonds in he Lehman index afer We also close our posiion on any bond ha drops off he Lehman Index. In addiion, in compuing he bond reurns of each firm, because a recenly issued bond is likely o be more acively raded han a seasoned bond (see Gebhard, Hvidkjaer, and Swaminahan (2005) and Duffee (1999)), we use he reurn on he mos recenly issued bond insead of he value-weighed reurn of all eligible bonds of a firm. This should furher minimize concerns abou daa errors affecing he calculaion of bond reurns. We implemen he bond accrual sraegies using his sub-sample and he resuls are presened in Table 4. Firs, noice ha he average number of firms per porfolio falls from abou 80 o 85 firms in Table 3 o approximaely 30 firms in Table 4. This is likely o reduce he power of hese ess o find abnormal performance. Neverheless, he resuls in Table 4 show ha he high accrual porfolio (P5) significanly underperforms he low accrual porfolio (P1) in Year 1. The underperformance in he firs year is 88 basis poins in he case of he NNI sraegy (Panel A) and 142 basis poins over he firs wo years in he case of he WCA sraegy (Panel B). This is lower han he roughly 200-basis-poin underperformance in Table 3 bu neverheless economically significan. Table 4 also provides resuls for he sample period beween 1992 and 1997 (excluding bonds wih unique feaures), which is he porion of our sample during which Lehman published highyield indices. There are only 60 monhly observaions wih abou 40 firms per porfolio in his sub-sample, which renders he findings vulnerable o sampling error and makes i difficul o draw srong conclusions. In spie of hese limiaions, he resuls coninue o show ha high accrual bonds underperform low accrual bonds. The underperformance in he case of he NNI sraegy is a significan 90 basis poins in he firs wo years while he underperformance in he case of he WCA sraegy is 92 basis poins in he firs wo years. A concern wih he addiional daa filers is he poenial for loss of power due o he reduced sample size. As we noed in Secion 3 (Panel C of Table 1), he median size rank of his subsample is 9, which shows ha his sub-sample consiss of he larges of he large firms in our original sample. Thus, i is possible ha he addiional filers are no only eliminaing firms wih daa errors bu hose wih he mos mispricing. To examine his possibiliy, we repor resuls of 17

20 he equiy accrual sraegies involving he same sub-sample in panels C and D of Table 4. The resuls show essenially ha he equiy accrual anomaly is economically smaller (compared o he numbers in Table 2) and in mos cases saisically insignifican in his sub-sample. This is no surprising because hese are really large firms where here is likely o be very lile mispricing of any kind and also because he smaller sample reduces he power o deec any mispricing. This suggess ha a leas some if no all of he weakening of he bond accrual effec is driven by dropping firms ha are more likely o be mispriced and no because of he reducion in daa errors. In subsequen ess, we focus on he larger sample from Table Raings and Duraion Adjused Corporae Bond Reurns The resuls presened in Table 3 are based on raw bond reurns wihou any adjusmens for risk. Could he accrual effec in bonds be explained by differences in sysemaic risk? For corporae bonds, he relevan risks are defaul and erm risks. Could he low bond reurns of he high accrual porfolio be explained by lower exposures o defaul and erm risk? To address his issue we compue risk-adjused bond reurns of he accrual porfolios. Specifically, we mach every bond in each accrual porfolio wih a benchmark porfolio wih roughly he same bond raing and duraion. To form he benchmark porfolios, we independenly sor all bonds available a he beginning of any given monh ino hree raing caegories AAA/AA, A, BBB and below and hree duraion caegories (by pariioning he sample ino hree groups based on duraion). The risk-adjused bond reurn is hen compued as he difference beween he raw bond reurn and he reurn on he corresponding benchmark porfolio. These adjused bond reurns are hen valueweighed (using he marke value of each bond) for each firm. The adjused firm level bond reurns are hen equal-weighed o compue porfolio reurns over he holding period. Table 5 presens hese resuls. Panel A presens risk-adjused bond reurns for sraegies based on ne new invesmen accruals, NNI, and Panel B repors resuls for sraegies based on working capial accruals, WCA. The reurns in Table 5 are smaller in magniude han hose in Table 3, suggesing ha some of he reurns earned by he accrual porfolios can be aribued o differences in defaul and erm risks. However, he risk-adjused reurns are sill quie large and boh economically and saisically significan. The resuls show ha he high NNI porfolio (P5) underperforms he low NNI porfolio (P1) on a risk-adjused basis by 102 basis poins in Year 1 (Panel A) while he high WCA porfolio (P5) underperforms he low WCA porfolio (P1) by 77 18

21 basis poins in Year 1 (Panel B). Boh hese numbers are significan a he 1% level. The resuls confirm he findings in Table 3 and sugges ha differences in defaul and erm risk canno fully explain he accrual effec in bond reurns. We also carried ou a raings and duraion adjused reurns analysis for he pos 1987 and 1992 filered samples discussed in Table 4. The resuls for NNI are similar o hose in he previous ables. The hedge reurns for he firs year subsequen o porfolio formaion are 35 and 37 basis poins for he wo periods respecively. Boh are saisically significan wih -saisics of 2.16 and 2.36 respecively. The hedge reurns using WCA are weaker han he raw reurn resuls. The hedge reurns for he firs period subsequen o porfolio formaion are no saisically significan, bu become significan in he second year subsequen o porfolio formaion wih reurns of 49 basis poins (-sa=4.06) and 32 basis poins (-sa=2.85) for he wo subperiod samples. This could be aribuable o he shorer sample periods and much smaller sample size hereby reducing he power of he ess (here are only abou 150 firms each year in he filered sample as opposed o over 400 firms each year in he enire sample) 4.5 Facor Risk Adjused Corporae Bond Reurns The risk adjusmens in Table 5 use characerisic mached porfolios o adjus for he defaul and erm risk of he accrual bond porfolios. The reurns repored were buy-and-hold abnormal reurns (BHAR) compued in even ime. In his secion, we perform risk adjusmens using a muli-facor model (consising of defaul and erm facors) ha uses monhly calendar ime excess reurns. 15 The calendar ime approach provides es saisics ha are beer specified han hose provided by he BHAR approach (see Fama (1998)). On he oher hand, calendar ime saisics may have lower power o rejec he null (see Loughran and Rier (2000)). Regardless of he relaive meris and demeris of he wo approaches, empirically, our objecive is o ensure ha our resuls are robus o alernae approaches o adjusing for risk. Following Fama and French (1993), we consider a five-facor model involving 2 bond marke facors and 3 sock marke facors for corporae bonds. One source of common facor risk for corporae bonds is erm risk, which arises from unexpeced changes in he erm srucure of 15 Gebhard, Hvidkjaer and Swaminahan (2005) find ha defaul and erm beas esimaed from facor models explain he cross-secion of corporae bond reurns beer han characerisics such as raings and duraion. 19

22 ineres raes. The oher source of common facor risk is he unexpeced change in defaul risk in response o changing economic condiions. We use TERM, defined as he difference in he monhly long-erm governmen bond reurn (from Cener for Research in Securiy Prices, CRSP) and one monh T-bill reurns (from CRSP), as a proxy for erm risk, and DEF, defined as he difference beween he monhly reurn on a value-weighed porfolio of all corporae bonds wih a leas en years o mauriy and he monhly long-erm governmen bond reurn, as a proxy for defaul risk. In addiion, we also include hree sock marke facors: Mk (excess reurn on he NYSE/AMEX/Nasdaq value-weighed index), SMB he size facor and HML he book-o-marke facor. While here are no a priori heoreical reasons for including hese sock marke facors, we include hem o ensure ha our resuls are no driven by omied risk facors. All our resuls are robus o a model ha conains only he defaul and erm risk facors. Finally, we consider a sixh facor, which is he conemporaneous monhly excess sock reurn earned by he high accrual (NNI or WCA) porfolio over he low accrual porfolio, (r e5 r e1 ). Since bond and sock reurns are posiively correlaed a he firm level, one concern abou finding an accrual effec in bond reurns is wheher i is simply a resaemen of he accrual effec in sock reurns. In oher words, here may be a mechanically induced accrual effec in bond reurns due o posiive conemporaneous correlaion beween sock and bond reurns of he same firm. We address his concern by adding (r e5 r e1 ) as an addiional facor. 16 The resuling 6-facor model is provided below: r r = a + b Mk + c SMB + d HML + e Def + f Term + g + b f ( r5 e r1 e ) u (13) where r b -r f represens excess reurns on corporae bond porfolios based on accruals, and he slope coefficiens represen he ex-pos facor loadings or beas. a is he inercep which represens he risk-adjused abnormal reurns or he alpha of he porfolio. Table 6 presens monhly risk-adjused reurns where he porfolios are formed a he beginning of each monh and he porfolio reurn compued for he monh +1 (recall ha we skip a 16 We have also esimaed regressions in which we use he excess sock reurn of he P1, P3, or P5 porfolios as he 6 h facor in regressions involving he bond reurns of he corresponding porfolios and he resuls are similar. 20

23 monh in beween o minimize microsrucure effecs). Panel A presens resuls for sraegies based on NNI and Panel B for sraegies based on WCA. The resuls show ha he high NNI porfolio (P5) significanly underperforms he low NNI porfolio (P1) by 8 basis poins per monh (96 basis poins annualized) on a risk-adjused basis (see column iled Inp. Panel B repors similar resuls for accrual sraegies based on WCA. The inercep corresponding o he P5-P1 porfolio is equal o 6 basis poins a monh (72 basis poins annualized), which is similar o he resuls in Panel B of Table 3 bu no saisically significan. Overall, he resuls confirm he findings in Table 3. The resuls also show ha he differences in defaul and erm beas beween he low accrual porfolio (P1) and he high accrual porfolio (P5) are quie small, suggesing ha he defaul and erm risks faced by he wo porfolios are quie similar. The beas corresponding o he sock marke facors for porfolios P1, P3, and P5 are low and economically insignifican hough some of hem are more han wo sandard errors away from zero, primarily because hese regressions have high R-squares due o he high explanaory power of he wo bond marke facors. Finally, he resuls seem o sugges ha here is no relaionship beween he sock reurn and he bond reurn of he P5-P1 accrual porfolio. This is misleading since his is a condiional resul obained afer conrolling for various risk facors. Univariae regressions involving jus he bond reurn and he sock reurn (no repored in a able) reveal a sronger relaionship. We examine his issue in more deail in Secion 4.7 using individual bond reurns. 4.6 Fama-MacBeh Cross-Secional Regressions In his secion, we run cross-secional regressions ha uilize bond reurns of individual firms and allow us o conrol for individual firm characerisics. Specifically, we esimae he following mulivariae regression involving accrual ranks, duraion, raings, and a dummy for equiy or deb offerings: r i + k = a + b Rnki, + c Raingsi, + d Duraioni, + e Issuei, + ui, + k, (14) where r i,+k represens corporae bond reurns over he subsequen k years and Rnk i, represens accrual ranks (Rnk = NNIRnk, WCARnk). The ranks based on NNI or WCA are compued each monh by forming 10 porfolios based on he corresponding accruals and hen assigning he 21

24 porfolio rank of 1 for firms in he low accrual porfolio and 10 for firms in he high accrual porfolio. 17 Using ranks is a way o miigae any noise in he accrual daa due o he presence of ouliers. Noe ha we conver leer raings o an ineger ranking ranging from 0 o 23 wih 0 represening AAA and 23 represening CC-. Thus, higher raings numbers represen higher risk and lower qualiy. Duraion is in number of years. Boh he raings and he duraion are compued a he firm level by averaging he corresponding values for all eligible bonds of he firm. Issue is a dummy variable equal o 1 if he firm issued deb or equiy in he previous 12 monhs and 0 oherwise. 18 As discussed in Secion 2, he issue dummy conrols for any underperformance in bond reurns following equiy or deb offerings. The regression is esimaed each monh and he ime-series average of monhly slope coefficiens and he corresponding ime-series -saisics are repored. Since fuure reurns are compued over overlapping 12 monh holding periods, he -saisics are compued using he Hansen-Hodrick auocorrelaion correcion wih 11 lags. The resuls from he cross-secional regressions are provided in Table 7. Panel A presens resuls involving NNI ranks (NNIRnk) and Panel B presens resuls involving WCA ranks (WCARnk). The resuls show ha accruals are significanly and negaively relaed o fuure bond reurns even afer conrolling for raings, duraion, and deb or equiy offerings a he individual bond level. Boh NNIRnk and WCARnk are significanly and negaively relaed o bond reurns over he nex wo years. Ineresingly, he issue dummy is also negaively relaed o long-erm corporae bond reurns, suggesing ha here is some underperformance in bond reurns following offerings o raise exernal capial. As expeced, boh raings and duraion are posiively relaed o fuure bond reurns, implying ha bonds wih high defaul and erm risk earn high reurns. Overall, he findings in Tables 5, 6, and 7 indicae ha sandard risk adjusmens canno fully explain he negaive cross-secional relaionship beween accruals and corporae bond reurns. 4.7 Sub-Period Analysis The earnings qualiy argumen would sugges ha he accrual effec would be sronger in periods where credi risk is higher. In his secion we examine wheher he reurn predicive abiliy of accruals varies in periods of high aggregae defauls. Daa on hisorical defaul raes from 17 Pariioning he firms ino 25 porfolios yielded similar resuls. 18 We obain daa on equiy and deb offerings from he Securiies Daa Corporaion (SDC). 22