Topic

How do bond investors

perceive dividend payouts

Journal Name
Research in International
Business
and Finance

Authors
Ike Mathur
Manohar Singh
Ali Nejadmalayeric
Pornsit Jirapornb

Country
United State

Artical Information
Received
29 March 2012
Revised form
16 July 2012
Accepted
23 July 2012
Available Online
28 July 2012

Nature Of Study
Secondary data was obtained from the
federal reserve board of governors
database

Problem statement
We want to explore that how investor view
corporate cash distributions through
dividends and how that view influences the
corporate cost of debt

STUDY OBJECTIVE
We explore how bond investors view corporate
cash distributions
through dividends
how that view influences corporate cost of debt
Explaining between 45 and 67 percent of
variance in credit spreads at the time of issuance
To explain the non-linear association between
dividend payouts and investment return expected

Significance
1 The literature is replete with studies that
examine the determinants of the cost of capital.
2 We contribute to this area of the literature by
showing that bondholders take into account
dividend payouts when determining bond yields.
3 The relationship, however, varies over
different ranges of dividend amounts.

Continued
4 Our results improve our understanding of the
role of dividends in corporate finance and
governance.
5 We find support both for the agency theory of
dividends and the signaling hyphothesis.

Continued
6 Our results aptly complement prior studies
that investigate the agency conflict between
shareholders and bondholders.
7 We demonstrate that bondholders regard
only large dividend payouts as an attempt to
redistribute wealth in favor of shareholders.

The Agency Conflict Hypothesis

This hypothesis recognizes the inherent conflicts between
bondholders and shareholders.
Black (1976) states that
a dollar paid out in dividends is a dollar that is not available to
the creditors if trouble develops.
Dhillon and Johnson (1994) report
The bond price reaction to announcements of large dividend
changes is opposite to the stock price reaction, suggesting the
existence of wealth redistribution.
Stockhammer (2010) suggests
Firms goals now prominently feature the rate of return on
equity. This is done by means of increasing payouts in the form
of dividends and via share buy backs. These developments
have come with lower rates of investment by firms and, at the
same time, with higher debt ratios of firms.

Floyd et al. (2012) and Acharya et al. (2011) offer

evidence that
Firms are reluctant to cut dividends even when facing
additional risks precipitated by the financial crisis. The
reluctance to lower dividends despite increased risk comes at
the cost of higher credit spreads.
SUGGESTIONS OF HYPOTHESIS:
Agency-cost-of-debt hypothesis suggests that bondholders
view large
dividends unfavorably. Firms that pay large dividends incur a
higher cost of debt as a result.
The hypothesis predicts a positive association between
dividend payouts and bond yields.

Sample Data and Variable

Description
Data Detail
Population:
All nonconvertible public debt issued by U.S. public nonfinancial corporations during the period from January
1970through December 2005. The sample includes
only the non-financial firms.
The data exclude bond issues with missing data on yield
and issuer characteristics, sample consists only of
nonconvertible public bond issues.
Data for T-bill yield and Treasury bond yield are obtained
from the Federal Reserve Board of Governors database.

Test Variables
Dependent variable:
The dependent variable is the credit spread of newly
issued corporate bonds for non-financial firms.
The credit spread is defined as the difference between the
corporate bond yield and the fitted yield on an otherwise
equivalent Treasury bond.
Independent variable:
To quantify the influence of dividend distributions on cost of
debt we take dividend yield as independent variable.
Dividend yield is defined as the dollar amount of dividends
paid during the four quarters prior to the debt issuance divided
by the month-end stock price closet to the issuance date.
=

Control variables:
Given that firms with higher default risk are expected to
have higher credit spreads, we control for several
macroeconomic, bond-specific, and firm specific
proxies for common default and recovery risk
factors.
Macroeconomic Conditions:
Both analytical and empirical models show that
macroeconomic conditions affect credit spreads. The riskfree rate rises, firms become more profitable and hence the
likelihood of default decreases. When a firms
profitability and interest rates are independent, changes in
the entire yield curve can affect corporate bond values by
influencing a firms bankruptcy costs.

 Firm-specific risk factors:

By definition, credit spread is linked to default risk.
measures of default risk, such as leverage and volatility,
are determinants of changes in credit-spread changes.
As such, we use five firm-specific measures of default
risk: firms profitability, leverage, Altmans Zscore, business risk, and asset tangibility.
Firm sensitivity to systematic factors:
To control for firm-specific sensitivities to these
systematic factors, we use the firms size (SIZE) and
market-to-book ratio (MB).
Chan and Chen (1991) suggest that firms with higher
values of market tobook (i.e., the ratio of the market value per share to book
value per share)have intrinsically higher equity risk.
Since prior research indicate that equity risk and default
risk are positively correlated, and a higher default risk

Empirical results
1: Univariate analysis:
We split the sample into five quintiles
based on dividend yield. Panel A shows
the results for all bond issuers. In Panel
B, we examine the multiple issuers.

Mean dividend yield

Mean yield spread

0.0011

2.4427

0.0116

1.1962

0.0221

1.1254

0.0367

1.3650

Highest dividend
quintile

0.0742

1.4386

Panel B: Multiple
issues
Lowest dividend
quintile

0.0002

3.0237

0.0105

1.4839

0.0231

1.2347

Panel A: All issues

Lowest dividend
quintile

Multivariate regression
analysis
We posit that dividend payout policies
influence corporate bondholders
view of a firms profitability and
riskiness, and therefore, its cost of
debt.
We analyze this issue in the
multivariate regression framework and
examine our hypothesis by estimating
the following model.

Regression Equation
Y = o+ 1DIVY + 2DIVYSQUARE +
3TBILL +
+ 4SIZE +

5MV + 6PROFIT +

 Our results suggest that bondholders

view dividend payouts as positive or
negative depending upon the levels of
dividends.
At the lower payout levels, dividends send
a positive signal to bondholders about a
firms future prospects, and hence, results
in lower cost of debt.
At higher levels of payouts bondholders
view payouts negatively and demand
greater return.

Exploring Endogeneity
3rd Classical Assumption:
Correlation between independent
variable and error term.

2003 tax cut

reduced the top marginal tax rate on dividends by
20 percent.
execute a two-stage regression.
construct a dummy variable equal to one for the
period after
2003 and zero for the period up to 2003.

1st Stage:
regress dividend payouts on the tax cut
dummy and the control variables.
Result: positive and significant, suggesting that
dividend payouts increase significantly after
the tax cut.
2nd Stage:
replace dividend payouts
by the predicted payouts from the first stage.
Result: negative and significant.

. Robustness of relation between

payouts and credit spreads overtime
It is suggested that corporate dividend policies
have changed overtime. The changing payout
policies may have bearing on our results.
In robustness analysis it was reported that in
the relation between dividend yield and credit
spreads holds consistently. In addition, control
variables also come up with consistent
estimated coefficients across all three subperiods. Thus, it appears that despite changes in
dividend policies, the bondholders perspective
on payouts has been consistent over time.

Conclusion:
Bond investors evaluate dividend payouts while
pricing corporate bonds.
The signaling hypothesis suggests that bondholders
view large dividend payouts as a positive signal and
as a result require a lower rate of return.
On the contrary, agency theory predicts that
dividends represent a wealth re-distribution from
bondholders to shareholders and, therefore, are
viewed negatively by bondholders.
The evidence reveals that both hypotheses are
supported, over different ranges of dividend payouts.

Conclusion continue..
In Particular, at lower levels of payouts, bond
investors interpret dividend distributions as a positive
signal about the superior future prospect of the firm.
And at a higher level of payouts, they interpret
dividend distribution as a detrimental to their
interest, and thus demand a higher return.
, although previous research suggests an early
disappearance and a recent resurgence of dividends
as payout mechanism, our results indicate that
relation between corporate credit spreads and
dividend payouts is robust across sample sub-periods.