Abstract:
We examine whether and how payout policy affects debtholder value using evidence from the credit default swaps (CDS) market. We find that CDS spreads increase in response to dividend cuts, suggesting that the signaling effect of dividend cuts dominates the wealth transfer effect for debtholders. Further, the signaling effect of dividend is more pronounced during recessions and among firms with high default risk. This finding is consistent with the view that firms are reluctant to cut dividends during financial distress, not because they use dividends to expropriate debtholders, but because dividend cutting conveys negative future prospect, which will hurt debtholders even more. We further show that dividend cuts are followed by higher probability of default and credit rating downgrades. We find little evidence that CDS spreads change in response to dividend increases or share repurchases.