Accrual Quality, Cost of Debt, and Credit Spread and Loss

Abstract

Our study presents a method to dissect bond excess returns into components influenced by credit spreads and credit losses. Analyzing data spanning 48 years, we find that companies with higher accrual quality experience greater shocks from credit spreads and lesser shocks from credit losses. Conversely, firms with lower accrual quality face reduced credit spread shocks but heightened credit loss shocks. This indicates that high accrual quality firms benefit more from credit spread shocks, while those with lower accrual quality profit more from credit loss shocks. Notably, excluding credit spread shocks, future realized returns have a negative correlation with accrual quality. These accrual quality premiums are significant both statistically and economically, especially when credit spread shocks are not considered. Additionally, accrual quality has improved over the past 48 years due to enhanced accounting standards. Our findings reveal the importance of a reliable accrual quality metric and underscore the need to factor in credit spread shocks in asset pricing evaluations.