Information Precision and the Term Structure of Credit Spreads: An Empirical Examination
by Inder K. Khurana of the University of Missouri,
September 6, 2003
Abstract: Prior empirical research has documented that credit spreads expected by theory tend to be lower than the observed credit spreads. To explain this discrepancy, Duffie and Lando (2001) argue that theory should consider the role of a firm's information precision in explaining credit spreads. Given that the asset values of a firm are not directly observable and hence must be inferred from a firm's accounting information that is less complete, Duffie and Lando predict that investors price a risk premium related to the imprecision of the available firm information. They also predict that the risk premia due to information imprecision moderates with debt maturity. Given that the value of the underlying assets drifts upwards with time, the reduced probability of default at higher asset value serves to mitigate the uncertainty due to imprecise accounting information. This paper empirically evaluates the two predictions using a sample of new debt issues. Consistent with theoretical predictions, we find a positive relation between measures of information precision and credit spreads and that maturity moderates the risk premia due to information precision. The results remain robust to the inclusion of other determinants of credit spreads as specified by theory.