R&D investments, bond ratings and bond risk premiums

The debate on whether corporate R&D investments should be capitalized as assets or expensed as incurred begs the question: which effect dominates—the future benefits from R&D investments or their riskiness? Extant R&D literature focusing on the relation between R&D variables and equity metrics is plagued with the inability of researchers to address this question. This is because both the benefits and riskiness of R&D have the same directional impacts on the equity valuation of levered firms (Merton 1973, 194). This study adds another dimension to the literature by assessing the combined effects of the future benefits and riskiness of R&D in the context of the bond market.; Option pricing theory stipulates that the mean (expected future benefits) and the variance (riskiness) of R&D investments play opposite roles in the pricing of bonds. Relying on this theoretical framework, I document significant positive associations of R&D variables with bond default risk and bond risk premium. This suggests that, for creditors, the risk of R&D appears to dominate the future benefits of R&D. In other words, creditors view R&D investments more like risk proxies than assets. Since the bond market has remained to be the firms' most significant external financing channel (Anderson et al., 1994), and R&D investments have become increasingly important to the U.S. economy, this paper generates new evidence for debates on the accounting treatment of intangibles.