The high-yield bonds of companies that use the greatest percentage of accruals to make up their earnings perform substantially worse than the bonds of companies that do not rely as much on accruals, according to a study expected to be released this week by Criterion Research Group. The study, Criteron's first on the fixed-income market, divided the companies in a Merrill Lynch High-Yield Index into 10 categories based on the component of accruals in their earnings, from smallest to largest. Next, it tracked the spread performance of the high-yield notes issued by these companies. The average spread on the bond of a company in the tenth decile widened by 123 basis points over the course of a year, while the average of a company in the top group tightened by 49bps, according to the study.
Neil Baron, chairman and co-founder of Criterion in New York, said that all other attributes such as credit rating and maturity being equal, the larger the amount of accruals in a company's earnings, the more likely it is to underperform its peers. "Accruals are management's estimate. There are different levels of subjectivity in accruals and because they are estimates, they can turn out to be wrong," he said. Practically speaking, he recommended high-yield investors divide companies into categories based on the proportion accruals make up of their earnings and invest accordingly. "If you are a hedge fund and you want to take a long/short strategy, you should go long first-decile bonds and short tenth decile ones. If you're a managed bond fund, you should invest more heavily in the low-decile companies," he explained.
Despite the ominous implication of companies in the higher deciles, Baron stressed that "the vast majority of companies in the tenth decile are in accordance with GAAP." That being said, he said fully half of all Securities and Exchange Commission enforcement actions and earnings restatements occur with companies in the ninth and tenth categories.