Research in International Business and Finance 27 (2013) 92–105

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Research in International Business

and Finance
j o ur na l h om ep ag e: w w w . e l s e v i e r . c o m / l o c a t e / r i b a f

How do bond investors perceive dividend payouts?

Ike Mathur a,∗, Manohar Singh b, Ali Nejadmalayeri c, Pornsit Jiraporn b
a
Department of Finance, Southern Illinois University, Carbondale, IL 62901-4626, United States
b
The Pennsylvania State University, Great Valley School of Graduate and Professional Studies, Malvern, PA 19355, United States
c
Spears School of Business, Oklahoma State University, Tulsa, OK 74106, United States

a r t i c l e i n f o a b s t r a c t

Article history: We explore how bond investors view corporate cash distributions
Received 29 March 2012 through dividends and how that view influences corporate cost of
Received in revised form 16 July 2012 debt. Explaining between 45 and 67 percent of variance in credit
Accepted 23 July 2012
spreads at the time of issuance, our model reveals a non-linear asso-
Available online 28 July 2012 ciation between dividend payouts and investment return expected
by bondholders. In particular, while bondholders view cash dis-
JEL classification: bursements in small amounts as a positive signal, large dividend
G32 payouts are viewed negatively. Our results thus provide support
G35
for both the signaling hypothesis and for the agency-cost-of-debt
Keywords: hypothesis. The results are robust even after controlling for firm
Dividend yield size, growth opportunities, profitability, leverage, business risk,
Bonds asset tangibility, and term structure. Exploiting the 2003 dividend
Costs of debt tax cut as an exogenous shock, we demonstrate that our results are
Credit spread not vulnerable to endogeneity problems. Finally, we find no evi-
Agency conflicts
dence of corporations timing the payouts strategically to influence
Wealth transfer
the cost of debt.
© 2012 Elsevier B.V. All rights reserved.

1. Introduction

Although much of the finance literature focuses on the impact of divided payout policies on equity
valuation, we show that payout policies are equally critical in determining the cost of corporate debt.
Additionally, the bond market constitutes one of the world’s largest security markets, with more than
$1.23 trillion of new corporate bonds issued in the U.S. in the first half of 2011 alone.1 The recent

∗ Corresponding author. Tel.: +1 6185811613; fax: +1 6184535626.

E-mail addresses: imathur@cba.siu.edu, imathur@msn.com (I. Mathur), m.singh@psu.edu (M. Singh),
ali.nejadmalayeri@okstate.edu (A. Nejadmalayeri), pxj11@gv.psu.edu (P. Jiraporn).
1
http://dmi.thomsonreuters.com/Content/Files/2Q2011 Global Debt Capital %20Markets Review.pdf.

0275-5319/$ – see front matter © 2012 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.ribaf.2012.07.001
 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105 93

literature has explored how the cost of debt is related to corporate governance (Sengupta, 1998;
Bhojraj and Sengupta, 2003; Anderson et al., 2003) to ownership structure (Boubakri and Ghouma,
2010), to managerial incentives (Ortiz-Molina, 2006), to CEO power (Liu and Jiraporn, 2010) and to
state laws (Wald and Long, 2007). One important dimension that affects the cost of corporate debt is the
bondholder–shareholder conflict. Bond prices are expected to reflect the extent to which bondholders
perceive risk of expropriation by shareholders. Dividend payouts may constitute one such mechanism
of expropriation by shareholders. The greater the perceived expropriation risk, the higher is the return
that the bondholders expect on their investment to compensate for the additional risk. Several prior
studies have examined the inherent conflict between bondholders and shareholders (Handjinicolaou
and Kalay, 1984; Woolridge, 1983; Jayaraman and Shastri, 1988; Maxwell and Stephens, 2003). The
evidence on wealth expropriation by shareholders from bondholders is mixed and the debate still
continues.
In this study, we contribute to the debate by investigating the impact of dividend payouts on the
perceived expropriation risk that gets reflected on the cost of debt. It is not settled as to how bondhold-
ers view dividend payouts. On the one hand, dividends represent a signal about the firm’s prospect
(Bhattacharya, 1979; Miller and Rock, 1985; John and Williams, 1985). A large dividend payout signifies
management’s confidence in the future cash flows of the firm. Dividends constitute a credible signal
because a reduction in dividends is usually met with a severe adverse market reaction. If this is the
case, bondholders should view firms that pay large dividends as less risky and hence require a lower
rate of return. On the contrary, dividends may exacerbate the agency conflict between bondholders
and stockholders. Dividends reduce the cash available to meet the firm’s predetermined obligations
including principle and interest payments on debt. Moreover, because of the adverse market reaction
associated with dividend reductions, many firms would rather borrow to avoid cutting dividends. The
additional leverage increases the firm’s risk with a consequent decrease in bond prices and an increase
in the cost of debt. To the extent that bondholders view dividends negatively, they demand a higher
rate of return from firms with large dividend payouts. This yields a positive relation between dividend
payouts and cost of debt.
Following prior studies (Fridson and Garman, 1998; Guntay and Hackbarth, 2010; Mansi et al., 2011;
Nejadmalayeri and Singh, in press), we employ the credit spreads of newly issued bonds by a firm to
measure its cost of debt. We use dividend yield as our measure of dividend payouts. Our findings are
particularly interesting in that the association between the cost of debt and dividend payouts is more
complex than generally postulated. Specifically, our evidence shows a non-linear relationship. When
dividend payouts are relatively small, bondholders view dividends positively; the higher the payout,
the lower the cost of debt. When firms distribute cash to stockholders in small amounts, bondholders
regard the distribution as a positive signal about the firm’s prospect. However, when dividend payouts
reach a certain amount, the relationship between payout and cost of debt turns negative. At higher
payout levels, bondholders feel threatened by the large cash outflows and thus demand a higher rate of
return, thereby increasing the cost of debt. Thus, the bondholder–shareholder conflict is exacerbated
only when dividend payouts reach a certain threshold. Below this threshold, dividends help reduce the
cost of debt. Our results remain robust even after controlling for a large number of variables such as firm
size, growth opportunities, profitability, leverage, business risk, asset tangibility, and term structure.
To handle possible endogeneity, we exploit the 2003 dividend tax cut as an exogenous shock. The
Jobs and Growth Tax Relief Reconciliation (JGTRRA) of May 2003 reduced the top marginal tax rate on
dividends by 20 percent and made it more tax-efficient to pay dividends. We employ as our instrument
a dummy variable that differentiates between the periods before and after the enactment of JGTRRA.
Our non-linear results hold even after accounting for possible endogeneity. Furthermore, we explore
the possibility of market timing, where firms may adjust their dividend payouts to influence the cost
of debt. Our empirical tests, nevertheless, reveal no evidence of strategic timing.
Our study contributes to the literature in several ways. First, the literature is replete with studies
that examine the determinants of the cost of debt (Longstaff and Schwartz, 1995; Kim et al., 1993;
Acharya and Carpenter, 2002; Elton et al., 2001; Ericsson and Renault, 2002; Longstaff et al., 2005;
Sengupta, 1998; Bhojraj and Sengupta, 2003; Anderson et al., 2003; Mansi et al., 2004; Ashbaugh
et al., 2006; Boubakri and Ghouma, 2010; Liu and Jiraporn, 2010; Wald and Long, 2007). We con-
tribute to this area of the literature by showing that bondholders take into account dividend payouts
94 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105

when determining bond yields. The relationship, however, varies over different ranges of dividend
amounts. Second, our results improve our understanding of the role of dividends in corporate finance
and governance. We find support both for the agency theory of dividends and the signaling hypoth-
esis. When dividend payouts are of a small size, bondholders view them as a favorable signal. Yet,
when the dividend amount goes beyond a certain point, bondholders perceive the distribution as
exacerbating the agency cost of debt and therefore demand higher bond yields. Finally, our results
aptly complement prior studies that investigate the agency conflict between shareholders and bond-
holders. Several prior studies attempt to ascertain whether dividend payouts represent a signal to
bondholders or a wealth re-distribution between shareholders and bondholders (Handjinicolaou and
Kalay, 1984; Woolridge, 1983; Jayaraman and Shastri, 1988; Dhillon and Johnson, 1994; Maxwell and
Stephens, 2003). We demonstrate that bondholders regard only large dividend payouts as an attempt
to redistribute wealth in favor of shareholders.

2. Theoretical background and hypothesis development

2.1. Conflicts of interest between stockholders and bondholders

The agency costs of debt generally arise from under-investment and asset substitution. Jensen and
Meckling (1976) and Myers (1977) describe how the existence of outstanding debt creates a moral
hazard problem, where stockholders’ interests diverge from the interests of creditors. Black (1976)
explains another agency conflict between bondholders and stockholders that centers on the firm’s
payout policy when firms distribute large payments to shareholders.
There exists prior empirical work that analyzes dividend policies to shed light on the conflicts of
interest between stockholders and bondholders. One approach is to examine the bond market’s reac-
tion to dividend announcement. The evidence, nevertheless, is mixed. For instance, Handjinicolaou
and Kalay (1984) and Woolridge (1983) report that bond prices are not affected by dividend increases
but react negatively to dividend reductions. These results are consistent with the signaling hypothesis
wherein payout reductions convey negative information about a firm’s future prospects. Jayaraman
and Shastri (1988) document significantly negative bond price reactions to special dividend announce-
ments. Dhillon and Johnson (1994) find that the bond price reaction to announcements of large
dividend changes is opposite to the stock price reaction. These latter studies suggest a significant
wealth-transfer effect of dividend from bondholders to shareholders.

2.2. Hypothesis development

The premise of this study is that bondholders take into consideration dividend payouts when deter-
mining bond yields. Nevertheless, from the theoretical perspective, it is not clear what the impact of
dividend payouts should be on the cost of debt. Three possible hypotheses are advanced below.

2.2.1. The irrelevance hypothesis

This hypothesis posits that there is no systematic relation between bond yields and dividend pay-
outs. Bondholders are aware of the potential conflicts of interest and expropriation by shareholders.
Consequently, bondholders place covenants on bonds to safeguard their interests. Most covenants put
restrictions on dividend payouts and cash distributions. To the extent that these covenants serve as
an effective mechanism to control the bondholder–shareholder conflict, dividend payouts should be
unrelated to bond yields.

2.2.2. The signaling hypothesis

This argument contends that dividends serve as a signal to investors about the prospect of the firm.
Signaling by dividends entails costs; shortfall in resources that requires raising capital, which is costly
(Bhattacharya, 1979; Ofer and Thakor, 1987), higher tax (John and Williams, 1985), or suboptimal
investment (Miller and Rock, 1985). These costs generate a separating equilibrium, where weaker
firms are not able to duplicate the signal. Firms employ dividends as an effective pre-commitment
device because dividend reductions and omissions elicit severe adverse market reactions. According
 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105 95

to this theory, firms that pay large dividends signal a favorable prospect of their future cash flows.
Bondholders recognize the positive signal and price the bonds higher. Thus, the positive signal through
payout results in lower bond yields. In other words, this hypothesis predicts an inverse association
between dividend payouts and bond yields.

2.2.3. The agency conflict hypothesis

Motivated by agency theory, this hypothesis recognizes the inherent conflicts between bondhold-
ers and shareholders. Black (1976) states that “a dollar paid out in dividends is a dollar that is not
available to the creditors if trouble develops.” A cash distribution through dividend can represent
wealth redistribution from bondholders to stockholders. A large number of studies have examined
this issue (Handjinicolaou and Kalay, 1984; Woolridge, 1983; Jayaraman and Shastri, 1988; Dhillon
and Johnson, 1994; Maxwell and Stephens, 2003). In particular, Dhillon and Johnson (1994) report
that the bond price reaction to announcements of large dividend changes is opposite to the stock
price reaction, suggesting the existence of wealth redistribution. Stockhammer (2010) observes that
firms give prominence to shareholders’ interests at the cost of debt holders. Specifically, he argues
that firms increase leverage to fund increased dividends, and that the increased dividends come at a
cost of lower investment rate. Emphasizing the crowding-out effect, Stockhammer (2010) suggests,
“Firms’ goals now prominently feature the rate of return on equity. This is done by means of increas-
ing payouts in the form of dividends and via share buy backs. Remarkably, these developments have
come with lower rates of investment by firms and, at the same time, with higher debt ratios of firms.”
Similar evidence is provided by Alzahrani and Lasfer (2012) suggesting that in the countries with
greater shareholder protection, firms repurchase more shares with an aim to increase the after tax
returns to their shareholders. More recently, Floyd et al. (2012) and Acharya et al. (2011) offer evi-
dence that firms are reluctant to cut dividends even when facing additional risks precipitated by
the financial crisis. The reluctance to lower dividends despite increased risk comes at the cost of
higher credit spreads. This is especially the case if the share repurchases are funded by additional
debt.
Given these arguments, agency-cost-of-debt hypothesis suggests that bondholders view large
dividends unfavorably. Firms that pay large dividends incur a higher cost of debt as a result. In
other words, the hypothesis predicts a positive association between dividend payouts and bond
yields.

3. Sample data and variable description

3.1. Data

We focus on the credit spread of newly issued bonds to avoid biases created by infrequent trading
and the illiquidity of secondary corporate bond markets. The initial sample consists of all nonconvert-
ible public debt issued by U.S. public non-financial corporations during the period from January 1970
through December 2005, for which data are available from the SDC database. The sample includes
only the non-financial firms. We exclude firms belonging to SIC 6000–6999. The rationale behind the
exclusion is as follows. Financial institutions face several regulatory restrictions including those on dis-
closures, scope of activity, leverage, capital requirements, liquidity, and equity capital levels. All these
firm level characteristics – influenced as they are by regulation – are expected to influence financial
firms’ risk levels and their payout policies, as well as the interaction between the two differently than
those for non-financial firms.
After excluding bond issues with missing data on yield and issuer characteristics, our sample
consists only of nonconvertible public bond issues for which valid COMPUSTAT accounting data are
available.
For accounting information during the period from 1970 to 2005, we use COMPUSTAT industrial
primary, secondary, and tertiary (PST), full coverage and research quarterly tapes. We use the annual
tapes to extract the most recent information for each firm and then match the accounting data with
the corresponding term structure and financing data. We use the most recent accounting information
as reported at the year-end prior to the issuance year. Data for T-bill yield and Treasury bond yield are
96 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105

Table 1
Descriptive sample statistics.

Variable Description Mean Median

YLDSPRD Credit spread, the difference between corporate bond’s yield and the yield 1.514 1.100
on the same-maturity Treasury bond at the time of issuance
DIVY Dividend yield 0.029 0.022
TBILL 3-month T-bill rate for month prior to issuance 4.922 5.000
TSPRD Treasury spread; the difference between the Treasury 10-year bond yield 1.267 1.100
and 3-month bill yield for month prior to issuance
TVOL 1-Year standard deviation of the Treasury spread for the month prior to 0.378 0.299
issuance
SIZE Natural log of market value of firm for the year prior to issuance 8.552 8.607
MB Ratio of market-to-book value of firm’s equity for the year prior to issuance 2.990 1.875
PROFIT Ratio of EBIDTA to sales for the year prior to issuance 0.199 0.172
LTDB Ratio of long-term debt to assets of firm for the year prior to issuance 0.364 0.357
ZPROB Altman’s Z-score for the year prior to issuance 1.451 1.364
BUSRSK 1-year standard deviation of PROFIT of firm for the year prior to issuance 0.032 0.021
FA Ratio of property, plant, and equipment to assets of firm for the year prior 0.490 0.481
to issuance

This table reports the mean and median of variables of interests and provides a description for each variable. The sample
includes newly issued corporate bonds during the period of 1970–2005 of all non-financial firms as reported by SDC for which
corresponding accounting and stock price information can be obtained from COMPUSTAT and CRSP databases. The interest
rates are from Federal Reserve Board of Governors’ database.

obtained from the Federal Reserve Board of Governor’s database. As for the macroeconomic variables,
the most recent information pertains to data available as of the month-end prior to the issuance month.
The summary statistics for the variables and variable descriptions are provided in Table 1.

3.2. Test variables

3.2.1. Dependent variable

Our dependent variable is the credit spread of newly issued corporate bonds for non-financial firms.
The credit spread is defined as the difference between the corporate bond yield and the fitted yield on
an otherwise equivalent Treasury bond. Following Duffee (1998) and Collin-Dufresne, Goldstein, and
Martin (2001), we use a linear interpolation scheme for the month-end treasury yield rates to approx-
imate the entire yield curve. Next, for each of the corporate bonds in our sample, by interpolation, we
find the corresponding treasury yield. We then define the credit spread (YLDSPRD) as the difference
between the Security Data Corporation (SDC) reported yield-to-maturity of the corporate bond and
the corresponding Treasury yield.

3.2.2. Independent variable

To quantify the influence of dividend distributions on cost of debt, following Becker et al. (2011) we
measure payouts in terms of dividend yield. Specifically, dividend yield is defined as the dollar amount
of dividends paid during the four quarters prior to the debt issuance divided by the month-end stock
price closet to the issuance date.
 t−1 
t−4
QuarterlyDividentt
Divyieldt =
SharePricet

3.2.3. Control variables

Given that firms with higher default risk are expected to have higher credit spreads, we control
for several macroeconomic, bond-specific, and firm-specific proxies for common default and recovery
risk factors. Table 1 provides the list of all variables with brief descriptions. The main control variables
are defined as follows.
 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105 97

3.2.3.1. Macroeconomic conditions. Both analytical and empirical models show that macroeconomic
conditions affect credit spreads. Contingent claim pricing models of corporate debt suggest that the
changes in the yield curve can affect the credit spread. Longstaff and Schwartz (1995) point out that
as the risk-free rate rises, firms become more profitable and hence the likelihood of default decreases.
Other studies (e.g., Kim et al., 1993; Acharya and Carpenter, 2002) show that even when a firm’s
profitability and interest rates are independent, changes in the entire yield curve can affect corporate
bond values by influencing a firm’s bankruptcy costs. Empirical studies also find that T-bill yield and
spread movements can partly explain the credit spread fluctuations.
Following yield curve models of term structure (Litterman and Scheinkman, 1991), we use a three-
factor yield curve model that includes: (1) the real T-bill yield (TBILL) as measured by the annualized
yield on the three-month T-bills for the month prior to the issue date; (2) the real Treasury term spread
(TSPRD) as measured by the difference between the thirty-year Treasury bond and the three-month
T-bill yields for the month prior to the issue date; and (3) the yield curve volatility (TVOL) as measured
by the standard deviation of monthly Treasury term spread for the year prior to the issue date.

3.2.3.2. Firm-specific risk factors. By definition, credit spread is linked to default risk. Elton et al. (2001)
show that a percentage of total credit spread can be attributed to the default risk. Collin-Dufresne,
Goldstein, and Martin (2001) show that measures of default risk, such as leverage and volatility, are
important determinants of changes in credit-spread changes. Acharya and Carpenter (2002) show
that measures of asset tangibility and volatility materially impact corporate bond recovery rates. As
such, we use five firm-specific measures of default risk: firm’s profitability, leverage, Altman’s Z-score,
business risk, and asset tangibility. We measure profitability (PROFIT) with the ratio of earning before
interest and taxes to total sales. Leverage is defined as the ratio of long-term debt to total book value of
assets (LTDB). Altman’s (1968) ZSCORE, as modified by MacKie-Mason (1990), ((2.3 EBIT + Sales + 1.4
Retained Earnings + 1.2 Working Capital)/Total Assets), measures default risk. Business risk (BUSRISK)
is the four-year standard deviation of profitability. Asset tangibility is the ratio of property, plant, and
equipment to total book value of assets (FA). As in Collin-Dufresne et al. (2001) and Chen et al. (2007),
we control for credit rating (CRD) as a possible determinant of credit spreads. We utilize COMPUSTAT’s
numerical equivalent of an average of Moody’s and S&P’s credit rating. A higher numeric value reflects
greater risk and is expected to relate positively to credit spreads.

3.2.3.3. Firm sensitivity to systematic factors. Elton et al. (2001) contend that credit spread partly rep-
resents the evolution of the systematic risk factors in the economy. Following Avramov et al. (2007),
to control for firm-specific sensitivities to these systematic factors, we use the firm’s size (SIZE) and
market-to-book ratio (MB). Chan and Chen (1991) suggest that firms with higher values of market-
to-book (i.e., the ratio of the market value per share to book value per share) have intrinsically higher
equity risk. Since prior research indicate that equity risk and default risk are positively correlated, and
a higher default risk implies higher credit spreads, the coefficient on the variable MB is expected to be
positive. However, since a smaller firm implies higher equity risk, the coefficient on the variable SIZE
is expected to be negative.

4. Empirical results

4.1. Univariate analysis

The results of the univariate analysis are shown in Table 2. We split the sample into five quintiles
based on dividend yield. Panel A shows the results for all bond issuers. The mean yield spread in the
lowest dividend quintile is 2.4427. Then, the mean yield spread declines in the next two quintiles.
However, the mean yield spread starts rising in the higher dividend quintiles. This pattern indicates
non-linearity, implying a negative association when the dividend yield is low and a positive relation
when the dividend yield is high. In Panel B, we examine the multiple issuers. Firms may adjust their
dividends to influence the cost of bond financing. However, bondholders can anticipate this strategic
action and adjust their expectations for later issues by the same firm. The evidence in Panel B, however,
98 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105

Table 2
Univariate comparison of credit spreads across dividend yield quintiles.

Mean dividend yield Mean yield spread Median dividend yield Median yield spread

Panel A: All issues

Lowest dividend quintile 0.0011 2.4427 0.0000 2.06
0.0116 1.1962 0.0119 0.86
0.0221 1.1254 0.0220 0.89
0.0367 1.3650 0.0361 1.10
Highest dividend quintile 0.0742 1.4386 0.0675 1.18
Panel B: Multiple issues
Lowest dividend quintile 0.0002 3.0237 0.0000 3.060
0.0105 1.4839 0.0107 1.070
0.0231 1.2347 0.0229 0.925
0.0393 1.3981 0.0386 1.120
Highest dividend quintile 0.0790 1.4615 0.0730 1.220

This table reports the mean and median of the yield spreads of newly issued bonds across dividend yield quintiles. The sample
includes newly issued corporate bonds during the period of 1970–2005 of all non-financial firms as reported by SDC for which
corresponding accounting and stock price information can be obtained from COMPUSTAT and CRSP databases. In Panel A are
reported all issues individually while Panel B reports average of multiple issues floated in one year.

shows a similar pattern as Panel A. There appears to be a non-linear association between payout and
credit spreads.

4.2. Multivariate regression analysis

We posit that dividend payout policies influence corporate bondholders’ view of a firm’s profitabil-
ity and riskiness, and therefore, its cost of debt. We analyze this issue in the multivariate regression
framework and examine our hypothesis by estimating the following model using a system GMM
approach:

y = ˛0 + 1 DIVY + 2 DIVYSQUARE + ˇ1 TBILL + ˇ2 TSPRD + ˇ3 TVOL

+ ˇ4 SIZE + ˇ5 MB + ˇ6 PROFIT + ˇ7 LTDB + ˇ8 ZSCORE + ˇ9 BUSRSK


22 
17
+ ˇ10 FA + ˇ11 CRD + m Yearm + n Industryn,t + ε
m=1 n=1

Here, y is the test dependent variable – a bond’s credit spread. Our independent test variable dividend
yield (DIVY) is defined as the dollar amount of dividends paid during the four quarters prior to the
debt issuance divided by the month-end stock price closet to the issuance date. We also test for
non-linearity by including a quadratic term DIVYSQUARE. The independent control variables are: the
3-month T-bill yield (TBILL), the difference between 30-year Treasury bond and 3-month T-bill yields
(TSPRD), the one-year standard deviation of TSPRD (TVOL), the natural log of firm’s total market value
(SIZE), the equity market-to-book ratio (MB), the ratio of EBITDA to sales (PROFIT), the long-term
debt to total asset (LTDB), Altman’s (1968) Z-score as modified by MacKie-Mason (1990) (ZSCORE),
the four-year volatility of PROFIT (BUSRSK), the ratio of property, plant, and equipment to total assets
(FA), and credit rating (CRD). All our independent variables are winsorized at the 1% level on each
side.
Given that our data are a large panel of newly issued corporate bonds, we follow the convention of
recent studies (Chen et al., 2007; Guntay and Hackbarth, 2010; Nejadmalayeri and Singh, in press) to
estimate our model using two different methods. First, we estimate Panel regressions with industry
and year dummies where we employ year and industry dummies to control for any clustering and
time dependencies. This approach ensures that autocorrelation is not influencing the results and that
the results are not conditional on observations being from a particular sample year. Second, to confirm
robustness of our findings, we estimate pooled cross-sectional regressions. Following Johnson (2003),
 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105 99

Table 3
Impact of dividend yield on credit spreads.

Panel regression Cross sectional regression

Intercept 10.842
(1.79)*
DIVY −12.488 −11.054
(−7.44)*** (−3.12)***
DIVYSQUARE 110.955 121.982
(7.83)*** (3.24)***
TBILL −0.047 −0.103
(−3.77) (−4.49)***
TSPRD −0.050 −0.084
(−2.30)** (−1.84)*
TVOL 0.868 0.982
(13.59)*** (6.93)***
SIZE −0.098 −0.112
(−7.58)*** (−5.19)***
MB −0.000 −0.0004
(−0.20) (−0.05)
PROFIT −1.146 −1.231
9 (−7.23)*** (−4.19)***
LTDB 1.406 1.235
(8.89)*** (4.59)***
ZSCORE −0.116 −0.091
(−4.55)*** (−2.13)**
BUSRISK 1.817 1.227
(3.98)*** (1.87)*
FA −0.116 −0.069
(−1.44) (−0.51)
CRD 0.477 0.741
(18.30)*** (18.00)***
Year dummies Yes –
Indus. dummies Yes –
Adjusted R2 0.4509 0.6764
Number of observations 6682 1202

This table reports the results of the regression analysis relating credit spreads and dividend yields. The sample only includes non-
financial firms (SIC 6000–6999 are excluded) that issued a non-convertible, public bond during the period 1970–2005 from
SDC database for which corresponding accounting information from COMPUSTAT can be found. The interest rates are from
Federal Reserve Board of Governors’ database. The results for panel (with year and industry dummies), and cross-sectional
regressions are reported. All coefficients’ standard deviations are corrected for heteroscedasticity using Newey–West method.
Our dependent variable, credit spread is defined as the difference between newly issued bond’s yield and the corresponding
Treasury bond’s yield. The corresponding bond’s yield is computed using a linear interpolation of constant maturity bonds’
yields. The dependent variable is then the credit spread of each issue.
*
Statistical significance at the 10% level.
**
Statistical significance at the 5% level.
***
Statistical significance at the 1% level.

we first take the time-series average of our variables and then estimate a cross-sectional regression.
This method avoids any serial correlation problems.
Table 3 displays the results of our regression analysis. In general, the findings with respect to our
main test variable support our univariate findings. The results in Model 1 show that the coefficient of
the dividend yield is negative and significant. Furthermore, the quadratic term of the dividend yield
carries a positive and significant coefficient. The results indicate that when the dividend yield is low,
bondholders interpret larger payouts as a positive signal and accordingly require a lower rate of return
with increasing payouts, yielding a negative relation between credit spreads and payouts. However,
when the dividend yield reaches a certain threshold, the relationship is reversed. When the dividend
yield is in the higher range, bondholders regard larger dividends as detrimental to their interests and
thus demand higher yields. The evidence thus suggests that bondholders do not view dividends as
threatening until they reach a particular threshold. In Model 2 – that captures only the cross-sectional
variation across firms – the results reinforce out findings in Model 1.
100 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105

Our models perform well within the sample. The R-squares for the panel and cross-sectional
regressions are 45% and 68%, respectively. The F-statistics indicate that our models are well specified.
With respect to control variables, our results are consistent with the findings of prior empirical
studies. As in Duffee (1998) and Collin-Dufresne, Goldstein, and Martin (2001), both T-bill yield and
Treasury spread relate negatively to credit spreads. The Treasury spread volatility, as predicted by
theory (Acharya and Carpenter, 2002), associates positively with credit spreads. Similar to Elton et al.
(2001), we find that a firm’s size significantly affects its credit spreads. Larger firms have smaller
spreads. As expected, all measures of default and recovery risk affect credit spreads adversely. As
expected, more levered and less profitable firms have larger credit spreads. Finally, firms with lower
credit quality and larger profit volatility have wider credit spreads. In sum, our results suggest that
bondholders view dividend payouts as positive or negative depending upon the levels of dividends. At
the lower payout levels, dividends send a positive signal to bondholders about a firm’s future prospects,
and hence, results in lower cost of debt. However, at higher levels of payouts – consistent with agency-
cost-of-debt hypothesis – bondholders view payouts negatively and demand greater return. Thus, for
larger payout firms, higher levels of dividends result in higher cost of debt.

4.3. Exploring endogeneity

Our hypotheses posit that the cost of debt is influenced by dividend payouts. Nevertheless, it is
conceivable that the direction of causality may be reverse. That is, managers may set dividend payouts
based on the cost of debt. To explore possible endogeneity, we utilize the 2003 dividend tax cut as an
exogenous shock. The Jobs and Growth Tax Relief Reconciliation (JGTRRA) of May 2003 reduced the
top marginal tax rate on dividends by 20 percent. This tax change was proposed and signed into law
with unusual speed, and thus represents a largely unanticipated and exogenous increase in the after-
tax value of dividends to individual investors. As a result, due to higher after-tax returns, dividend-
paying stocks should become more attractive to investors. In response, managers should respond by
increasing payouts. In sum, one should expect corporate dividend payouts to increase after the passage
of JGTRRA in 2003. We use this exogenous increase as an instrument in our two-stage estimation
model.
We execute a two-stage regression. We construct a dummy variable equal to one for the period after
2003 and zero for the period up to 2003. In the first-stage regression, we regress dividend payouts on
the tax cut dummy and the control variables. Then, in the second stage, we replace dividend payouts
by the “predicted” payouts from the first stage. This way we capture exogenous dividend increases –
not determined by previous credit spreads – to explain variance in corporate bond yields. The results
are shown in Table 4. Model 1 represents the first-stage regression. As expected, the coefficient of the
tax cut dummy is positive and significant, suggesting that dividend payouts increase significantly after
the tax cut. Model 2 is the second-stage regression. The coefficient of the predicted dividend payouts
is negative and significant, whereas the quadratic term carries a positive and significant coefficient.
Taken together, the evidence suggests that the direction of causality likely runs from dividend payouts
to the cost of debt than vice versa. The 2003 dividend tax cut provides an exogenous shock not related
to the cost of debt and allows us to have a relatively clean identification strategy. Control variable
coefficients are consistent with the results previously reported in Table 3.

4.4. Exploring market timing

The agency-cost-of-debt hypothesis suggests that bondholders may view dividend payouts as a
form of wealth transfer to equity holders. This is expected to result in higher cost of debt for higher
dividend paying firms. As a result, firms may strategically reduce dividend payouts before issuing
bonds in order to reduce the cost of debt financing. To explore this possible strategic timing, we
distinguish between firms that lower dividend payouts before issuing bonds and those that do not.
We employ the three-year average payout ratio before and after the issuance year to classify our
sample firms. The average payout ratio is calculated as cash dividends divided by earnings. Table 5
shows the regression results. Model 1 includes only firms where the average dividend payout ratio has
not declined before issuing bonds. Model 2, on the contrary, includes those that have decreased the
 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105 101

Table 4
Two-stage analysis of causality: impact of dividend yield on credit spreads.

(1) (2)
First stage Second stage

Intercept 0.056*** 1.158***

(13.59) (3.22)
Dividend Tax Cut 0.0131*** –
(7.17)
DIVY (Predicted) – −33.231***
(−5.43)
DIVYSQUARE (Predicted) – 296.514***
(10.13)
TBILL 0.003*** −0.010
(14.00) (−0.51)
TSPRD 0.002*** −0.030
(4.43) (−1.30)
TVOL 0.009*** 0.820***
(5.70) (9.56)
SIZE −0.002*** −0.121***
(−8.57) (−7.47)
MB −0.009*** −0.026***
(−6.96) (−3.24)
PROFIT −0.021*** −1.309***
(−5.73) (−7.12)
LTDB 0.023*** 1.677***
(7.73) (9.51)
ZSCORE −0.005*** −0.170***
(−9.94) (−4.76)
BUSRISK −0.061*** 0.081
(−7.57) (0.16)
FA 0.027*** 0.226
(15.01) (1.33)
CRD −0.010*** 0.479***
(−26.55) (8.34)
F-stat. 260.23*** 388.24***
Adjusted R2 0.44 0.56

This table reports the results of regression analysis relating credit spreads and dividend yields controlling for possible endo-
geneity. In the first-stage regression, dividend payouts (dependent variable) are regressed on the tax cut dummy (independent
variable) and the control variables. In the second stage, dividend payouts are replaced in our original model by the “pre-
dicted” payouts (independent variables) from the first stage to estimate causal effect of dividends on credit spreads. The sample
only includes non-financial firms (SIC 6000–6999 are excluded) that issued a non-convertible, public bond during the period
1970–2005 from SDC database for which corresponding accounting information from COMPUSTAT can be found. The interest
rates are from Federal Reserve Board of Governors’ database. Our dependent variable, credit spread is defined as the difference
between newly issued bond’s yield and the corresponding Treasury bond’s yield. The corresponding bond’s yield is computed
using a linear interpolation of constant maturity bonds’ yields. The dependent variable is then the credit spread of each issue.
*
Statistical significance at the 10% level.
**
Statistical significance at the 5% level.
***
Statistical significance at the 1% level.

average dividend payout ratio prior to issuance. The dividend payout ratio variable exhibits positive
and significant coefficients both in Model 1 and Model 2. The similar results in Model 1 and Model 2
suggest that firms do not appear to engage in any strategic timing of dividend payouts. With respect
to the control variables’ coefficients, the overall results are consistent with the ones reported earlier
in the paper. However, some interesting differences across the two sets of firms emerge. First, better
financial health – measured in terms of Z-score – remains relevant in reducing the cost of debt for the
non-decreasing payout firms only. Favorable effects of financial strength do not materially decrease
credit spreads for payout-decreasing firms. For these firms, declining dividends send a strong enough
negative signal about their future prospects to make even their positive financial health irrelevant.
Second, higher business risk significantly raises cost of debt for dividend decreasing firms only. That
is, for the dividend reducing firms, negative factor – business risk – becomes materially relevant
102 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105

Table 5
Impact of dividend yield on credit spreads by dividend policy.

(1) (2)
Non-decreasing payouts Decreasing payouts

Intercept 0.498 22.185***

(0.06) (2.55)
DIVY −8.865*** −14.583***
(−3.73) (−5.03)
DIVYSQUARE 71.701*** 127.753***
(3.55) (5.33)
TBILL −0.036** −0.071***
(−2.07) (−3.94)
TSPRD −0.051 −0.074**
(−1.72) (−2.20)
TVOL 0.773*** 0.749***
(8.89) (6.57)
SIZE −0.115*** −0.088***
(−5.73) (−3.78)
MB −0.005 −0.003
(−0.52) (−0.29)
PROFIT −1.313*** −0.908***
(−5.33) (−3.51)
LTDB 1.352*** 1.396***
(6.04) (5.44)
ZSCORE −0.165*** −0.079
(−4.73) (−1.61)
BUSRISK 1.142 1.216**
(1.93) (2.07)
FA 0.048 −0.274***
(0.41) (−2.38)
CRD 0.591*** 0.541***
(18.86) (14.77)
Industry dummies Yes Yes
Year dummies Yes Yes
Adjusted R2 0.619 0.476

This table reports the results of the regression analysis relating credit spreads and dividend yields for subsamples of firms
based on dividend payout changes prior to issuing debt. Non-decreasing payout (dividends-to-earnings ratio) firms are the
ones whose average dividend payout ratio did not declined before issuing bonds. Decreasing payout firms are those firms
that witnessed reduced average dividend payout ratio prior to issuance. The sample only includes non-financial firms (SIC
6000–6999 are excluded) that issued a non-convertible, public bond during the period 1970–2005 from SDC database for
which corresponding accounting information from COMPUSTAT can be found. The interest rates are from Federal Reserves
Board of Governors’ database. Our dependent variable, credit spread is defined as the difference between newly issued bond’s
yield and the corresponding Treasury bond’s yield. The corresponding bond’s yield is computed using a linear interpolation of
constant maturity bonds’ yields. The dependent variable is then the credit spread of each issue.
*
Statistical significance at the 10% level.
**
Statistical significance at the 5% level.
***
Statistical significance at the 1% level.

in adversely affecting their cost of debt. Finally, the presence of tangible fixed assets is materially
important for reducing the cost of debt for the dividend decreasing firms only. The evidence indicates
support for the signaling hypothesis in that paying lower dividends actually sends a negative signal to
bondholders about poor future prospects of the dividend lowering firms. Specifically for these firms,
the bondholders look for better financial strength, lower business risk, and higher tangible collateral
assets while pricing debt.

4.5. Robustness of relation between payouts and credit spreads overtime

It is suggested (see, for example, Floyd et al., 2012, among others) that corporate dividend poli-
cies have changed overtime. The changing payout policies may have bearing on our results. To test
the robustness of our reported non-linear relation between dividend payouts and credit spreads, we
 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105 103

Table 6
Impact of dividend yield on credit spreads – period subsamples.

Panel regression pre-1990 Panel regression 1990–1999 Panel regression 2000–2005

Intercept −7.875 164.121 529.533

(−.54) (4.68)*** (3.08)***
DIVY −18.271 −17.888 −11.083
(−5.24)*** (−5.79)*** (−2.99)***
DIVYSQUARE 128.086 180.281 101.806
(5.27)*** (4.79)*** (2.31)***
TBILL −0.051 −0.158 −0.273
(−2.66)*** (−4.13)*** (−2.98)***
TSPRD −0.156 −0.221 −0.303
(−4.65)*** (−3.68)*** (−1.86)*
TVOL 0.461 0.390 0.280
(5.98)*** (2.19)** (1.26)
SIZE −0.026 −0.118 −0.112
(−1.03) (−6.77)*** (−3.25)***
MB −0.001 −0.007 −0.007
(−0.07) (−1.03) (−1.44)
PROFIT −0.862 −1.016 −1.388
(−2.34)** (−4.08)*** (−4.62)***
LTDB 1.268 1.499 1.020
(3.72)*** (6.00)*** (3.45)***
ZSCORE −0.041 −0.101 −0.116
(−0.75) (−2.48)** (−4.55)***
BUSRISK 1.511 1.649 1.127
(2.01)** (2.42)** (0.96)
FA −0.147 −0.114 −0.094
(−0.68) (−0.99) (−0.67)
CRD 0.479 0.490 0.526
(10.66)*** (9.97)*** (12.77)***
Year dummies Yes Yes Yes
Indus. dummies Yes Yes Yes
Adjusted R2 0.3881 0.5267 0.5111
Number of observations 1885 3332 1465

This table reports the results of the regression analysis relating credit spreads and dividend yields for three different subsample
periods. The sample only includes non-financial firms (SIC 6000–6999 are excluded) that issued a non-convertible, public bond
during the period 1970–2005 from SDC database for which corresponding accounting information from COMPUSTAT can be
found. The interest rates are from Federal Reserve Board of Governors’ database. The results for panel (with year and industry
dummies), and cross-sectional regressions are reported. All coefficients’ standard deviations are corrected for heteroscedasticity
using Newey–West method. Our dependent variable, credit spread is defined as the difference between newly issued bond’s
yield and the corresponding Treasury bond’s yield. The corresponding bond’s yield is computed using a linear interpolation of
constant maturity bonds’ yields. The dependent variable is then the credit spread of each issue.
*
Statistical significance at the 10% level.
**
Statistical significance at the 5% level.
***
Statistical significance at the 1% level.

estimate our base model for three distinct sub-periods namely, period of an early disappearance (1970s
and 80s), followed by a recovery (1990s), and finally the period of recent resurgence (post-2000) of
dividends as payout mechanism. The results are presented in Table 6. We report that in all three
sub-periods, the non-linear U-shaped relation between dividend yield and credit spreads holds con-
sistently. In addition, control variables also come up with consistent estimated coefficients across
all three sub-periods. Thus, it appears that despite changes in dividend policies, the bondholders’
perspective on payouts has been consistent over time.

5. Conclusions

Bond investors evaluate dividend payouts while pricing corporate bonds. The signaling hypothesis
suggests that bondholders view large dividend payouts as a positive signal and as a result require
a lower rate of return. On the contrary, agency theory predicts that dividends represent a wealth
104 I. Mathur et al. / Research in International Business and Finance 27 (2013) 92–105

re-distribution from bondholders to shareholders and, therefore, are viewed negatively by bondhold-
ers. The evidence reveals that both hypotheses are supported, albeit over different ranges of dividend
payouts. In particular, at lower levels of payouts, bond investors interpret dividend distributions as a
positive signal about the superior future prospect of the firm and accordingly require a lower yield.
By contrast, when dividend payouts reach higher levels, bond investors regard large cash distribu-
tions as detrimental to their interest, and thus, demand a higher return. This leads to higher cost of
debt for firms. Corporate finance executives involved in raising debt capital will find these results
particularly relevant. The results demonstrate that dividend payout strategies materially impact cost
of debt. Our results also suggest that managers may not be able to strategically time the payouts
around debt issuance to reduce the cost of debt. Further, dividend reduction by firms prior to debt
issuance seems to make debt investors focus more on financial health, business risk, and asset quality
of such debt-issuing firms. These factors become significantly relevant for investors pricing the bonds
of dividend-reducing firms. Finally, although previous research suggests an early disappearance and
a recent resurgence of dividends as payout mechanism, our results indicate that relation between
corporate credit spreads and dividend payouts is robust across sample sub-periods.

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