Abstract
We investigate the credit market’s response via changes in credit default swap (CDS) spreads to management earnings forecasts and evaluate the importance of these forecasts relative to earnings news during the periods before and during the recent credit crisis. We document that credit markets react significantly to management forecast news and that the reactions to forecast news are stronger than to actual earnings news. Consistent with the asymmetric payoffs to debt holders, the forecast news is mainly relevant for firms with poor credit rating or announcing bad news. We also show that the relevance of management forecasts to credit markets is particularly strong during periods of high uncertainty, as experienced during the recent credit crisis.
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Notes
As an example, a report issued by Standard & Poor's in June 2010 discusses the CDS market reaction and the rating agency's decision to change the outlook on the company as a result of Nokia’s management forecast revisions (Standard & Poor's 2010).
Most CDS contracts are standardized to increase the tradability of the contract. Typically, the contracts are triggered when a specified credit event (debt restructuring, default, bankruptcy) occurs for any of the debt of the reference entity. The most liquid contracts are 5-year contracts, although 1-, 3-, 7-, and 10-year contracts are also traded.
CDS contracts can be also settled in cash whereby the protection seller pays the buyer the difference between the face value of the debt and its current value.
Although there is evidence that bond prices lag stock prices in incorporating firm specific information (Kwan 1996), there is no such lag in CDS price responses. If any, the evidence from studies comparing the speed of price reactions across CDS market and stock markets suggests that the CDS market leads the stock market. For instance, Acharya and Johnson (2007) find evidence that the CDS market leads the stock market when firms experience adverse credit events. Also, Norden and Weber (2004) document that the CDS market reacts earlier than the equity market to rating agency announcements. However, Longstaff et al. (2005) do not find a clear lead for either the stock market or the CDS market.
For instance, good news in a management forecast might increase the likelihood of a firm raising dividend payments or conducting share repurchases, which causes credit markets to react negatively, but leads to a positive response in the share market (see Dhillon and Johnson 1994).
Recent research investigates the impact of other information providers to debt markets, bond analysts (DeFranco et al. 2009; Johnston et al. 2009). This research finds that bond analysts' reports provide relevant information in debt pricing. In unreported sensitivity tests, we control for the presence of bond analyst reports over a five-day window around the management earnings forecast announcement date and find qualitatively similar results.
Rogers and Van Buskirk (2009) observe that bundled forecasts have become more common recently, increasing from approximately 15% of forecasts in the late 1990s to 75% of forecasts in 2007.
Although Veronesi (1999) also makes predictions about equilibrium price responses to news in periods when investors are relatively certain about the state of the economy being bad, we do not consider this scenario as this characterization does not fit any part of our sample period (2001–2008).
We prefer to scale by the absolute value of forecasts rather than by the stock price, since Cheong and Thomas (2010) find that forecast errors and seasonally differenced earnings per share do not vary with the stock price. However, our results are robust to scaling by the stock price, as well as to including the inverse of the stock price as an additional explanatory variable in the regression.
In the case of range estimates, we follow Anilowski et al. (2007) and compute management earnings forecasts as the average of high and low estimates when First Call’s CIGCODEQ equals ‘B,’ the lower estimate when CIGCODEQ equals ‘G,’ and the higher estimate when CIGCODEQ equals ‘H.’
We obtain qualitatively similar results when we drop management forecasts announced simultaneously with rating agency announcements. We lose a total of 114 observations for the unbundled sample and 119 observations for the bundled sample when we remove management forecasts simultaneously disclosed with rating agency announcements.
In early July 2007, Moody’s and Standard & Poor's downgraded 399 and 612 tranches of subprime mortgage backed securities respectively. Also, investment bank Bear Stearns informed investors on 7 July 2007 that they will get little, if any, of the money invested in two of its hedge funds after rival banks refused to bail them out.
Unreported correlation statistics (Spearman rank order) for the unbundled and bundled forecast samples indicate that the CDS spread changes are significantly negatively correlated with MF News, contemporaneous market-adjusted stock returns (Stock Return), S&P 500 Return, and Good Rating News, while they are significantly positively correlated with ΔVIX and Bad Rating News.
Although the Hausman and the Breush and Pagan tests indicate that OLS regressions are the most appropriate regressions for our sample relative to either a fixed-effects or a random-effects model, our conclusions remain unaltered when these alternative estimation methods are employed.
To maximize the sample size in analysis of bond spreads, we selected bonds that trade around the management forecast announcements using a flexible five trading day window (e.g., bond yields on days −3 and day +1 or bond prices on day −1 and day +1 could be selected when computing the change in bond spreads around the announcement date). Bond spread changes are changes in bond yields adjusted for maturity and coupon matched Treasury bills' yields. We scale the changes in bond spreads by the number of days in the window (up to five) to control for potential differences that might arise due to different window sizes. We obtain a smaller sample of 2,866 observations but from a larger pool of 599 firms.
In analysis of qualitative management forecasts, we employ the methodology in Anilowski et al. (2007) to classify qualitative forecasts into good or bad news forecasts. We then replace MF News in Equation (1) with a dummy variable for bad news forecasts. Although the conclusions obtained using qualitative forecasts are identical to those obtained from Table 2, we refrain from drawing strong conclusions from the regressions of qualitative forecasts, as this sample consists of only 407 observations. Of these, only 38 qualitative forecasts are issued during the crisis period.
We also analysed the reactions after splitting forecast news into good, bad and neutral groups as done in Kim et al. (2010). For the good and bad news groups, we continue to obtain qualitatively similar results to those reported here. In both the pre-crisis and the crisis period, we find insignificant CDS spread reactions to neutral news.
When we interact MF News with Habitual and estimate the regressions separately for the good news and bad news sub-samples, we find that, in the pre-crisis period, the credit market reacts to bad news but not to good news and that the market reaction does not depend on whether the forecast is habitual. However, during the crisis, credit markets react to both good and bad news but only when the forecasts are issued by habitual forecasters.
One could potentially argue that this larger market reaction to preannouncements is due to preannouncements primarily containing bad news, which as shown earlier are more value relevant to credit markets. However, contrary to this argument, we find (in untabulated analyses) that the preannouncements cause larger market reactions only when forecasts contain good news.
To address potential self-selection biases from managers choosing to issue bundled forecasts, we add inverse Mills ratios as controls in the regressions. We estimate the probability of issuing a bundled management earnings forecast in a first stage Probit regression as done in Rogers and Van Buskirk (2009), except that we do not control for whether the firm held a conference call when announcing earnings, as we do not have access to this data. We run the model using annual averages for the variables. In unreported results, we find no evidence of self-selection (i.e., the coefficients on the inverse Mills ratios are always statistically insignificant) and our main results remain unchanged.
We exclude dummies for good rating news and bad rating news in these regressions as there are insufficient observations in the matched unbundled sample to estimate the coefficients on these variables.
Since it is possible that managers strategically bundle forecasts with an earnings announcement when the earnings news is negative, we do not compare the results for the bundled sample with those for the unbundled sample. For both samples, our focus is on the relative importance of management forecasts and earnings announcements within each sample (and not across samples).
In the unbundled sample, we find the coefficients for both good forecast news and good earnings news to be insignificantly different from zero and also insignificantly different from each other.
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Acknowledgments
We acknowledge helpful comments from three anonymous reviewers, Karthik Balakrishnan, Jeff Callen, Jim Ohlson, Mark Clatworthy, Doron Nissim (the editor), David Reeb, Scott Richardson (discussant), and participants at the 2010 Review of Accounting Studies Conference, 2010 HKUST Accounting Research Symposium, 4th Manchester Business School/LSE Accounting Conference, Tel Aviv University, and Turku School of Economics. We thank Viral Acharya for graciously sharing the CDS Markit data with us. Oktay Urcan and Florin Vasvari acknowledge the financial support from London Business School Research and Materials Development Fund.
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Shivakumar, L., Urcan, O., Vasvari, F.P. et al. The debt market relevance of management earnings forecasts: evidence from before and during the credit crisis. Rev Account Stud 16, 464–486 (2011). https://doi.org/10.1007/s11142-011-9155-6
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DOI: https://doi.org/10.1007/s11142-011-9155-6