Is the Tone of Risk Disclosures in MD&As Relevant to Debt Markets? Evidence from the Pricing of Credit Default Swaps^*

Abstract

This paper examines whether the tone of corporate textual disclosures related to risk and uncertainty conveys relevant information to the credit default swap (CDS) market. Prior studies largely focus on the amount of risk disclosures and provide inconclusive evidence on the usefulness of risk disclosures for investors in assessing firm risk. Using a large sample of textual risk disclosures in the Management's Discussion and Analysis (MD&A) section of 10‐K and 10‐Q filings, I predict and find that the change in CDS spreads over the three‐day window surrounding the 10‐K/Q filing date is positively associated with the pessimism of the language used in the risk disclosures. I conduct several analyses to show that the effect of the tone of risk disclosures is distinguishable from that of the amount of such disclosures. Cross‐sectional analyses reveal that the CDS market reaction to the tone of MD&A risk disclosures is more pronounced for reference entities closer to default, consistent with creditors' particular concern about downside risk. Further, the CDS market reacts more significantly to the tone of MD&A risk disclosures for reference entities with a weaker information environment. Overall, these results support the view that the tone of textual risk disclosures in MD&As has information content for investors in the CDS market in particular and debt markets in general. My findings improve the understanding of textual risk disclosures by showing that the tone and the amount of such disclosures have different implications for debt market investors' risk perceptions.

Does Accounting Conservatism Discipline Qualitative Disclosure? Evidence From Tone Management in the MD&A*

“…An emerging academic interest in soft information has been reinforced by various studies showing that linguistic tone is relevant to information users. Li (2010b), Feldman et al (2010), Loughran and McDonald (2011) and Davis et al (2012) find significant market responses to the tone of managerial communications, and Wang (2018) finds that the tone of the MD&A helps debt market investors evaluate credit risk. Since the tone of qualitative disclosure is relevant to information users and affects their decisions, managers have incentives to manipulate perceptions in their disclosure narratives.…”

Linguistic attributes and trade credit: Evidence from textual analysis of earnings conference calls

“…We further examine other aspects of managers’ linguistic tones of the customer firm in the presentation section of conference calls. Prior literature shows that uncertain and risk language is relevant to credit default swap (CDS) market and associated with more rating disagreement (Bonsall & Miller, 2017; Wang, 2021). Thus, we follow Loughran and McDonald (2011) and use their word lists to construct litigious tone and uncertain tone.…”

“…Furthermore, Bonsall and Miller (2017) find that more positive tone in 10‐K filings is associated with more favorable credit ratings, indicating tone conveys incremental information beyond the disclosure content and predicts future defaults. Wang (2021) shows that the negative sentiment in borrowers’ risk disclosures is positively associated with the change in CDS spreads in the three‐day window surrounding issuance of the relevant 10‐K or 10‐Q filings. Therefore, tone can be used by managers as a signal to describe firm prospects and default risks.…”

Managerial tone and investors' hedging activities: Evidence from credit default swaps

“…First, to the best of our knowledge, this study is the first to explore the impact of narrative disclosure tone on investor hedging activities in the CDS market. Prior studies have principally examined investors' decision‐making behaviour in traditional stock markets (Davis et al, 2012; Feldman et al, 2010; Loughran & McDonald, 2011) and/or the CDS price discovery effect (Tsai et al, 2016; Wang, 2021). In particular, our paper is related to but different from the paper by Wang (2021), which investigates the impact of MD&A tone on CDS spread.…”

“…For example, Tsai et al (2016) show that a negative tone in public news articles is regarded as an indicator for higher credit risk for CDS market participants, indicating that investors in the CDS market impound linguistic tone into CDS pricing. In a similar vein, Wang (2021) documents that the tone of the Management Discussion and Analysis section (MD&A) of a firm's 10-K/Q report conveys relevant information to CDS market investors to evaluate the CDS price. While there is a booming stream of studies on the price discovery effects, considering the significant role for hedging purposes via risk transfer, research on whether and how the disclosure tone affects investor hedging activities in the CDS market is still nascent.…”