American Accounting Association 2006 Midwest Region Meeting March 30 – April 1 Chicago, Illinois

Friday, March 31, 10:20 a.m.-12:00 noon
Concurrent session 2E - Transparency and Analyst Forecasts (Financial Accounting and Reporting)

Title: Continuous versus Categorical Bond Ratings: the Role of Analysts’ Forecasts in Bond Pricing

Yanling Guan London Business School

ABSTRACT: This study examines the role of analysts’ forecasts from bond investors’ perspective. The main argument is that the categorical bond ratings may contain limited information to bond investors about default risk and thus bond investors may use all available information including analysts’ forecasts to convert categorical ratings back to continuous bond ratings. Accordingly, I expect analysts’ forecasts to provide incremental explanatory power to bond yield premium after controlling the categorical bond ratings. In addition, I expect that the continuous bond ratings outperform the categorical bond ratings in explaining bond yield premium. Henceforth, this study aims to empirically test these two hypotheses.

I extract new bond issuance from Security Database Corporation (SDC) and the final sample comprises a pooled sample of 763 observations. The results show that analysts’ forecasts provide significantly incremental explanatory power in explaining bond yield premium, especially when perceived default risk is high and when information asymmetry is high. I further find that the above-documented association does not change significantly after regulation Fair Disclosure (FD) took effect and does not depend on the use of the proceeds from debt financing. Furthermore, I show that such association is driven by the possibility that bond investors use analysts’ forecasts together with other available information to develop continuous and thus more differential ratings to complement original categorical bond ratings in pricing bonds. The results imply that grouping probability of default into limited categories of bond ratings may add rather than reduce information noise to bond investors.

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