CDS Trading Initiation, Information Asymmetry, and Dividend Payout

Abstract

This study uses the information asymmetry framework of DeAngelo, DeAngelo, and Skinner (2008) to examine the effect of initiation of credit default swaps (CDS) trading on firm dividend payout policy. This leads us to consider three channels through which CDS initiation can affect dividends. We find evidence that CDS initiation is associated with increasing dividends, which is consistent with two channels: firms distributing excess free cash flow to mitigate exacerbated manager-equityholder agency conflicts resulting from reduced monitoring by banks following CDS initiation, and firms having a higher incentive to pay out free cash flow because external financing costs are lower as a result of information provided by CDS trading to the equity market. Additional findings corroborate the first channel by showing that the dividend increases are concentrated among borrowing firms whose lead arranger banks have a relatively less strong reputation in the loan syndication market, and firms whose loans are subject to less intense monitoring features, i.e., less restrictive loan covenants, following CDS initiation. Additional analyses suggest that dividend increases following CDS initiation are not attributable to a wealth transfer from debtholders to equityholders, and that inferences are robust to controlling for the potential effects of CDS initiation on capital structure.