Corporate Bond Risk from Stock Dividend Uncertainty

California Institute of Technology Working Paper No. CALT-68-2435

14 Pages Posted: 20 Jun 2003

See all articles by Mark B. Wise

Mark B. Wise

California Institute of Technology

Peter B. Lee

Lehman Brothers, New York

Vineer Bhansali

LongTail Alpha, LLC

Multiple version iconThere are 2 versions of this paper

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

Wise, Mark B. and Lee, Peter Byungho and Bhansali, Vineer, Corporate Bond Risk from Stock Dividend Uncertainty (May 19, 2003). California Institute of Technology Working Paper No. CALT-68-2435. Available at SSRN: https://ssrn.com/abstract=410843 or http://dx.doi.org/10.2139/ssrn.410843

Mark B. Wise (Contact Author)

California Institute of Technology ( email )

Pasadena, CA 91125
United States
626-395-6687 (Phone)
626-568-8473 (Fax)

Peter Byungho Lee

Lehman Brothers, New York ( email )

745 Seventh Avenue
New York, NY 10019
United States

Vineer Bhansali

LongTail Alpha, LLC ( email )

500 Newport Center Drive
Suite 820
Newport Beach, CA 92660
United States

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