Corporate Bond Risk from Stock Dividend Uncertainty
Posted: 20 Sep 2004
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. With dividend yields at multi-decade lows 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: corporate bond, stock dividend, default probability
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