A recent draft paper by Alan V.S. Douglas, Alan G. Huang & Kenneth R. Vetzal (all of the School of Accounting & Finance, University of Waterloo), Cash Flow Volatility and Corporate Bond Yield Spreads demonstrates that there is pricing information in firms’ cash flow volatility that is not captured by more usual metrics:
Control variables were
- Issuer Credit Rating
- Years to Maturity
- Coupon Rate
- Liquidity
- Debt Servicing Ability
- Leverage
- Equity return volatility
- Term Structure Level
- Term Structure Slope
A fundamental determinant of firm value is cash flow. Accordingly, the uncertainty or volatility associated with cash flow should be reflected in default probabilities and bond yield spreads. This paper tests the cross-sectional, inter-temporal and overall relationships between volatility and spread using both expected and historical measures of cash flow volatility. We find that cash flow volatility is economically significant in explaining yield spreads. Expected cash flow volatility explains 51 basis points of yield spread in the univariate regression, and 17 basis points after controlling for the commonly used spreadinformative variables. Historical cash flow volatility explains yield spread with a similar magnitude. Importantly, we show that the cash flow volatility effect is robust to the closest proxies of asset volatility used in the literature, namely, stock return volatility, accounting earnings volatility, and analyst forecast dispersion of earnings. Our study highlights the importance of cash flow uncertainty risk in pricing corporate bonds.
This paper is an interesting extension of the Merton Model; it would be most interesting to see how this measure of risk has evolved in importance over time.