Information quality and the cost of debt capital

Abstract

Information plays a crucial role in the operation of financial markets, and the quality of accounting information concerns the interests of all the information users. My thesis investigates the effect of information quality on the cost of debt capital measured by credit/bond rating, offering yield spread, and bond covenants. In terms of information quality, I calibrate the precision and composition of the information set with respect to a firm based on the methodology of Barron, Kim, Lim and Stevens (1998). To empirically examine the relationship between information quality and the cost of debt, I collect two test samples: credit rating sample (8,062 firm-year observations) and new bond issue sample (1,504 bond issues). The data on credit ratings, bond issues, financial items, and analyst forecasts come from Compustat, FISD and IBES. My thesis documents the following main findings. First, higher information precision is related to more favorable credit rating, thus a lower cost of debt financing, while information composition (the proportion of total information that is public versus private) is not significantly related to credit rating. Second, there is a significantly negative relation between total information precision and offering yield spread of new bond issues, and the effect of information precision on the offering yield spread is economically significant. However, inconsistent with the conjecture of Easley and O'Hara (2004) and the equity market evidence provided by prior literature, I do not find in my sample that the composition of the information set with respect to a firm has significant effect on bond yield spread. Third, the impact of information precision on credit rating and offering yield spread is more pronounced for firms and bond issues with higher default risk (non-investment-grade rating and higher leverage) than for those with lower default risk (investment-grade rating and lower leverage). Fourth, more precise public and private information can improve firms' credit ratings and reduce the offering yield spreads of their bonds, suggesting that both public and private information are valuable for rating agencies and investors to evaluate the debt issuers and bond issues. Fifth, higher information precision with respect to bond issuers is associated with a smaller number of covenants in their bond contracts. The results of Three-stage Least Squares regression indicate that the effects of information precision are robust to the simultaneous determination of offering yield spread and bond covenants. My thesis contributes to the literature by providing direct evidence that rating agencies and bond investors take into account the information quality of debt issuers when evaluating the creditworthiness and risk of debt issuers and their bond issues. Also my thesis develops the research on the cost of debt capital in that to the best of my knowledge this is the first study to examine jointly the effects of information quality on the price term (offering yield spread) and non-price terms (covenants) of bond contracts.