Corporate Bond Risk from Stock Dividend Uncertainty
California Institute of Technology Working Paper No. CALT-68-2435
14 Pages Posted: 20 Jun 2003
There are 2 versions of this paper
Corporate Bond Risk from Stock Dividend Uncertainty
Date Written: May 19, 2003
Abstract
The capital structure of a firm is composed of equity and debt. In the Merton approach, equity holders hold a call option on the firm value, while bond holders are short a put on the firm value. Dividends paid to holders of equity provide them with current cash flow. The pay out of dividends to the equity holders devalues a firms debt since it increases its probability of default. In the bull market of the 1990's, many corporations suspended payout of dividends to stockholders, retaining the earnings to finance growth and operations. However, with dividend yields at multi-decade lows, and dim prospects for growth of many corporations in the immediate future, many investors are simply not willing to invest in non-dividend paying equity. It seems likely then that in the future some companies that do not currently issue dividends will begin paying dividends and some companies that currently only pay a small dividend will increase their dividend yield. Hence holders of the bonds for a firm that does not presently pay dividends (or pays a small dividend) have "dividend risk" associated with the possibility that at some time in the future the company will start issuing dividends to its stock holders (or increase its dividend rate if it currently pays a small dividend). In this paper we explore the consequences of future dividend increases for bond prices and default probabilities.
Keywords: Dividends, Corporate Bonds, Default Probability
JEL Classification: G00, G12
Suggested Citation: Suggested Citation
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