Firms return capital to their equity investors through their “payout policy.” In the case of “dividend payouts,” money is usually transferred to shareholders’ accounts at regular intervals. Despite the tax disadvantage, dividend payouts remain economically significant and resilient. However, we do not yet know how dividend payout raises and cuts affect credit risk. Delving into this issue for the first time, HKUST’s Chu Zhang and his colleagues discovered that changes in dividends signal changes in firm risk. This compelling new work has far-reaching implications for corporate payout policy.

Dividend policy is the structure of dividend payouts, the amount and timing of which should be aligned with a company’s long-term growth. While excessive dividends are no good thing and can lead to financial distress, regular payouts can reassure shareholders of the company’s financial health. “Maintaining the existing dividend level has been widely perceived by managers as a priority on par with investment decisions,” say the authors. But dividend levels inevitably change. When this happens, how is credit risk affected?

There are two predictions about the effect of dividend policy on firm value. First, the wealth-transfer hypothesis claims that dividend raises transfer wealth from debtholders to equity holders, and vice versa. In contrast, the information hypothesis proposes that dividend changes help firm executives to convey firm value information to outside investors. “To adjudicate on the two hypotheses,” say the authors, “we take a fresh look at this issue using evidence from the credit default swap (CDS) market.”

The researchers analyzed 12,716 dividend announcements made by companies between 2001 and 2014. Generally, there were more dividend raises than cuts, and cuts were larger in magnitude. As a novel measure of the change in firm default risk, the authors extracted “CDS spreads,” which are “a better and cleaner measure of firm credit risk.” They then looked at how dividend changes affected CDS spreads.

CDS spreads increased significantly around announcements of dividend cuts and decreased modestly around announcements of dividend raises. Dividend cuts sparked the strongest reactions. Moreover, this reaction was strongest in firms with high credit risk and negative past stock performance. This suggests that “the information effect of dividend changes dominates the wealth-transfer effect for debtholders,” explain the authors.

Second, CDS reactions to dividend cuts were stronger for financial firms than for industrial firms. This is consistent with the notion that the informational role of dividend cuts is more important for financial firms because of their more opaque nature. “The information effect is stronger when dividend cuts reflect more of the firms’ own economic conditions,” say the authors, “but is weakened when dividend decisions are influenced by government interventions.”

This innovative work shows that dividend cuts convey useful negative information to the credit market and can help to predict future credit rating downgrades. “An unnecessary dividend cut may mislead the market and cause the CDS spreads to rise and debt value to fall, hurting debtholders much more than the wealth transfer would benefit them,” conclude the researchers.