This study investigates the impact of earnings, including the accrual and cash flow components of earnings, on firm credit risk as reflected in Credit Default Swaps (CDS). The CDS is essentially a "pure credit" default instrument and provides a far less noisy measure of credit risk by comparison to other debt instruments. Moreover, the credit derivative market, which is dominated by CDS contracts, is a multi trillion dollar market (notional value) that has roughly doubled in size each year for the past five years. To gain some perspective, the global credit derivatives market is currently estimated to be more than four times the size of the investment-grade global corporate bond market.
The very existence of the CDS market and its burgeoning growth are prima facie evidence that other debt markets are unable to provide adequate solutions for the trading of credit risk. Thus, it is our contention that the CDS market is the best venue within which to investigate the extent to which earnings and its components are determinants of credit risk, and far superior to the heterogeneous corporate bond and secondary loan markets.
Two other studies investigate the impact of earnings on CDS rates with conflicting results. In regressions that include two earnings regressors, earnings normalized by sales and the coverage ratio (earnings normalized by interest expense), Benkert (2004) finds that both earnings variables are positively and significantly associated with increased credit risk. In a study contemporaneous with ours, Batta 2006) obtains the result that the coverage ratio is negatively and significantly associated with increased credit risk, primarily for low coverage ratio levels.
These contradictory results could be due to a number of factors that we explore in the analysis that follows. Two factors that come immediately to mind are the issue of scaling and sample size. Scaling earnings by interest expense could induce a negative association with CDS spreads that is totally unrelated to earnings and is entirely driven by the denominator the interest expense. Consider, for example, what happens when interest rates decline or interest payments fall because the firm retired some of its debt.
The interest coverage increases if earnings remain constant, whereas CDS spreads should decrease because the default risk is lower. Thus, the negative relationship obtained by Batta (2006) can be expected simply because coverage mixes in the effects of both interest rate risk and leverage.3 In addition, as described below, Benkert's sample is far larger than Batta's.
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The Impact of Earnings on the Pricing of Credit Default Swaps
