The Influence of Differences in Taxable Income and Book Income on the Bond Credit Market

Abstract

ABSTRACT: We examine the importance of information pertaining to the relationship between taxable income and reported book income to bond rating analysts. Specifically, using a relatively large sample of new bond issues over an extended period of time, we examine information related to deferred taxes as well as the overall tax-to-book position in the assessment of a firm's default risk. Our results are consistent with the existence of a U-shaped relationship, with firms falling in the extreme upper or lower quintiles of their industry-year group receiving lower bond ratings than firms that are nearer to their industry average. Additional analyses suggest this effect is partially diminished for firms identified as highly effective tax planners. Finally, examination of investors' bond yields provides further corroborating evidence with respect to the importance and treatment of the information provided by the firm's overall tax-to-book position.