Corporate Payout Policy and Credit Risk: Evidence from CDS Markets

Abstract

We examine whether and how payout policy affects credit risk using evidence from the credit default swap (CDS) market. We separately analyze industrial firms and financial firms because of their distinct differences in risk-shifting incentives and information opacity. For industrial firms, CDS spreads increase substantially in response to dividend cuts, especially during recessions and among firms in financial distress. In contrast, CDS spreads have muted reactions to dividend raises and share repurchases. Additional investigation suggests that dividend cuts predict future credit rating downgrades. For financial firms, the results are robust and even stronger for dividend cuts. Collectively, our results are consistent with the information content effect of dividend cuts broadly dominating the wealth transfer effect for debtholders, especially for financial firms. Exploiting Troubled Asset Relief Program (TARP) as an exogenous shock to dividend policy, we further confirm the information effect of dividend cuts on credit risk.

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

JEL Classification: G12, G14, G1