Chengzhu Sun, Shujing Wang, Chu Zhang

Management Science, 67(9), 5755–5775, 2021

Recommend Reason

Despite the tax disadvantages and lack of flexibility, dividend payouts remain economically significant and resilient. A prominent empirical regularity suggested by previous literature is that firms usually increase dividends gradually and rarely cut them. Maintaining the dividend level has been widely perceived by managers as a priority on par with investment decisions. However, the impact of a dividend cut on credit risk has not been well understood. We provide a fresh look on this issue using evidence from the CDS market. The paper discovers that CDS spreads increase significantly around announcements of dividend cuts and decrease modestly around announcements of dividend raises, which suggests that, on average, the information content effect dominates the wealth-transfer effect for debtholders. The negative CDS market reaction to dividend cuts is more pronounced during recession periods and among firms with high credit risk and negative past stock performance, further supporting the dominant information content effect of dividend cuts on credit risk, especially among firms in financial distress. Our study also adds to the debate on dividend policies by separately examining industrial firms and financial firms. The information content effect of dividend cuts is particularly strong for financial firms, potentially due to their inherent opaque nature.

About the author

Chengzhu Sun, School of Accounting and Finance, Hong Kong Polytechnic University

Shujing Wang, Department of Economics and Finance, School of Economics and Management, Tongji University

Chu Zhang, Department of Finance, The Hong Kong University of Science and Technology

Keywords

Credit default swaps, Dividend announcements, Industrial firms, Financial firms, Troubled Assets Relief Program

Brief Introduction

We examine whether and how payout policy affects credit risk using evidence from the credit default swap (CDS) market. CDS spreads increase substantially in response to announcements of dividend cuts, especially during recessions and among firms experiencing financial distress. CDS spreads also react more strongly to permanent and less anticipated dividend cuts. The size of the CDS reaction is more pronounced for financial firms, which are inherently more opaque. In contrast, CDS spreads react weakly to dividend raises and share repurchases. The results show that the information effect of dividend changes dominates the wealth-transfer effect.

Link: https://pubsonline.informs.org/doi/epdf/10.1287/mnsc.2020.3753