Corporate fraud matters if you control firm leverage: evidence from the Russian bond market

Abstract

Importance: financial market turbulence and worldwide economic decline present new challenges to the participants of the bond market. One of these challenges is related to the quality of information on firms’ activities provided to stakeholders. Purpose: identifying price anomalies in the rouble bond market caused by expectations of fraudulent activities of corporate issuers towards the falsification of information revealed in financial statements (accounting fraud) and of the firms capital structure. Methods: we consider four working hypotheses on the influence of the capital structure and the tendency of firms towards fraudulent activities on the falsification of reported information. We examine the excess returns and factor model based risk-adjusted returns of bond portfolios consisting of firms with different levels of fraud risk controlling firm capital structure and then check whether our results are robust with respect to bond market hidden states. We use the Hidden Markov Model to recover the sequence of bond market states based on spread of 30-year minus 3-months government bond yields. The authors performed data analysis in RStudio. The sample covers the period from January 2011 to December 2022. Results: this paper provides evidence of the significant contribution of the newly proposed risk factor, corresponding with corporate fraud controlling for firm capital structure, to the explanatory power of asset pricing models for bond portfolios excess returns. We then introduce hidden bond market states based on spread of government bond yields and show that proposed market states are statistically and economically significant. We further examine the state-dependent explanatory power of the risk factors for test portfolios. We find the strong evidence that the rouble corporate bond market is ineffective in relation to information on the possible firms accounting fraud. Conclusions: Investors in the Russian bond market should account for bond exposure to the accounting fraud risk factor in the risk-adjusted performance analysis of bond portfolios.