Review of Quantitative Finance and Accounting, 25: 233–253, 2005
2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.
Earnings Predictability, Bond Ratings, and Bond Yields
AARON D. CRABTREE
Assistant Professor of Accounting, School of Accountancy, CBA 389, P.O. Box 880488,
University of Nebraska-Lincoln, Lincoln, NE 68588-0488, Tel: 402.472.1753
JOHN J. MAHER
Professor and Mahlon Harrell Research Fellow, Department of Accounting and Information Systems,
Pamplin College of Business, Virginia Tech, Blacksburg, VA 24061-0101, Tel: 540.231.4505 Fax: 540.231.2511
Abstract. We examine the role that earnings predictability plays in establishing a ﬁrm’s cost of debt capital
by measuring its inﬂuence on establishing a new issue’s bond rating. In addition, we also examine the effects of
earnings predictability on the initial pricing of the ﬁrm’s debt. Using new corporate bond issues from the period
1990–2000, our results indicate that the degree of predictability of a ﬁrm’s earnings is positively associated with
a ﬁrm’s bond rating. Moreover, earnings predictability is also documented to be negatively associated with the
offering yield. Importantly, bond rating classiﬁcation accuracy is improved when speciﬁc measures of a ﬁrm’s
earnings predictability are added to a robust model.
Substantial attention has been directed towards analyst forecasts and earnings surprises in
the accounting and ﬁnance literature during the past decade.
The ability to meet consensus
analysts’ forecasts and achieve predictable earnings is often considered an especially de-
sirable ﬁrm attribute.
Existing empirical evidence indicates managers behave in a manner
consistent with endeavoring to achieve analysts’ earnings forecasts, which implies aim-
ing for predictable earnings patterns.
An important question relates to the existence of
veriﬁable ﬁrm beneﬁts associated with predictable earnings. We investigate this issue by
examining the relationship that exists between predictable earnings and bond ratings and
bond yields. We provide empirical evidence that ﬁrms whose earnings are more predictable
have lower costs of debt capital.
Our research examines the inﬂuence predictable earnings have on the default risk of the
ﬁrm as represented by its bond rating at the time of issuance. We further investigate the
effects of earnings predictability directly on establishing the initial pricing of the ﬁrm’s
debt. We measure earnings predictability in two ways: ﬁrst, as the difference between the
ﬁrm’s actual earnings and consensus analysts’ forecasts; and second, as the dispersion of
the individual analysts’ forecasts. These measures differ from traditional earnings volatil-
ity measures previously utilized in bond rating models in the following important ways.