JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS VOL 28,NO 4,DECEMBER 1993 Bond and Stock Market Response to Unexpected Earnings Announcements Sudip Datta and Upinder S.Dhillon* Abstract This study examines whether earnings changes convey information in bond markets and finds a significant positive (negative)reaction to unexpected earnings increases (decreases). The results are consistent whether earnings announcements precede or follow dividend announcements.Thus,earnings surprises convey information to bond markets and changes in firm value are split among bondholders and stockholders.This is in contrast to evidence from studies examining unexpected dividend announcements where bond price reaction is asymmetric.Cross-sectional analysis reveals that bond excess returns are positively related to earnings surprises. I.Introduction Stock market reaction to earnings announcements has received significant attention in the finance and accounting literature.Ball and Brown(1968),Brown (1978),Watts(1978),Aharony and Swary (1980),and Fried and Givoly (1982)are some of the studies that observe a revision of stock prices associated with the release of earnings information.Lev (1989)provides a survey of research in this area.The explanation for the above empirical findings is that unexpected earnings provide new information about future cash flows.Furthermore,the classical discounted cash flow model predicts a revision in firm value that is the present value ofexpected future cash flows.Whether this increased firm value accrues to stockholders and bondholders is an empirical issue.Past research on the information content of earnings has focused solely on stock price behavior and finds at least part of the benefits accrue to stockholders. In this study,we examine the bond market reaction to unexpected quarterly earnings announcements.The study is unique for several reasons.First,dividends, repurchases,and earnings are considered primary mechanisms used by manage- ment to convey information about future cash flows to securityholders.Recent *Bentley College,Department of Finance,Waltham,MA 02254,and SUNY-Binghamton.School of Management,Binghamton,NY 13902-6000,respectively.The authors thank Doug Emery,John Gardner,Bert Horwitz,Herb Johnson,Mai Iskandar,Dennis Lasser,Indu Ravi,and Sara Reiter for their helpful comments.They are especially indebted to an anonymous JFQA referee who provided many suggestions that substantially improved the paper.The authors are also grateful to I/B/E/S Inc. for providing the analyst forecast data.The first author gratefully acknowledges a summer research grant from Bentley College. 565