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

This paper finds that the corporate bonds of firms with high accruals underperform corporate bonds of firms with low accruals. Our results show that an accrual measure that includes capital investments provides higher and more statistically significant underperformance than a measure that includes only working capital investments. In the first year after portfolio formation, the underperformance is 118 basis points using the capital investment accrual measure and 50 basis points using the working capital accrual measure. The Sharpe ratios of the zero-investment bond accrual portfolios are as high as those of the zero-investment stock accrual portfolios, suggesting that these results are economically significant. The bond accrual results are robust to risk adjustments based on both a factor model consisting of default and term risk factors and a characteristics model based on bond ratings and duration. Cross-sectional Fama-MacBeth regressions that use individual bond data confirm the time-series portfolio findings. Regression tests that control for the contemporaneous correlation between stock and bond returns of the same firm show that the bond accrual strategies continue to be profitable even after controlling for the profitability of the equity accrual strategies. Overall, our results raise an interesting question as to why the corporate bond market, despite incentives to focus on cash flows rather than reported earnings, is unable to determine earnings quality any better than the stock market