IMPACT OF DIVIDEND CHANGES ON THE INDIAN CORPORATE

BOND MARKET: SIGNALING EFFECTS

Prof. Varadraj B. Bapat

Vice-Principal,
S. K. Somaiya College of Arts, Science and Commerce,
Vidyavihar, Mumbai-400077

ABSTRACT

Corporate bond market is an important segment of financial market in terms of

funds raised as well as potential for future growth though is sparsely
researched. One of the two propositions on impact of dividend changes is
signaling hypothesis (Bhattacharya, 1979) which suggests a positive effect on
bond prices, on an announcement of dividend increase; whereas the other one is
wealth transfer hypothesis (Handjinicolaou and Kalay, 1984) which proposes a
negative impact on bond prices due to extortion of wealth from bond holders.
By studying the impact of dividend policy decisions on Indian corporate bond
prices, the paper examines these hypotheses and contributes to the literature on
payout policy.

Dividend increase and decrease announcements of 5% or more during a period

of 5 years from year 1997-98 to 2001-02 have been identified and abnormal
returns for bonds and stocks are computed. The analysis shows that abnormal
bond and stock returns are positive and are statistically significant in the event-
month in case of dividend increase. It is concluded that signaling hypothesis is
found to hold in Indian corporate bond market.
1. INTRODUCTION

Payout policy of a firm is one of the most important areas in corporate finance.
Managers have to decide about the amount and type of the payout repeatedly
and regularly. Though a number of theoretical explanations have been proposed
in the literature to explain the payout policy, the empirical support is scanty.
The changes in corporate laws permitted share repurchase in the Indian market,
however cash dividend continues to be the most prominent form of payout to
the owners of the firm. The limited work on corporate dividend decisions in the
Indian market have mainly focused on the valuation effects and determinants of
firms’ dividend payout. Most of these studies have documented the behavior of
share prices and profitability/earnings measures around dividend changes.
There are no studies which would provide evidence on effect of payout policy
on corporate bond prices.

Corporate debt market has remained highly underdeveloped segment of Indian

financial markets. On one hand bond issues from corporates are very low, with
most of the corporate borrowing still made up of institutional and bank loans,
on the other hand, most of the retail investors perceive corporate bonds nearly
as risky as equity and do not show significant inclination in investing in
corporate bonds. During 1996-2001, due to bearish trend in equity market
companies sought to approach debt market but showed preference for private
placements over public issues. Efforts by regulators to discourage private
placement market have improved the number of listed bonds and market
capitalisation in 2003-04; however we are yet to experience vibrancy in
corporate bond market. In nineties, primary market for financial institutional
issues is fairly developed, with ICICI and IDBI repeatedly approaching the
market and successively raising significant amounts. Despite this secondary
market lacks both width and depth, evidenced by thin trading and a few
investors. Though corporate debt market is still immature, its significance
cannot be undermined. Policy makers have realized importance of development

2
of bond market and are making all-out efforts to achieve the same. This further
makes it imperative to add to little available literature on fixed income market.

By using a data set of share and bond prices, this study addresses the question
that whether dividend changes support the signaling hypothesis or the wealth
transfer hypothesis.

The remainder of this paper is organized as follows. Section two presents a

review of the relevant literature. Section three describes the analytical method
utilized and sample characteristics; section four presents empirical results and
the last section depicts the conclusions.

2. REVIEW OF LITERATURE

Miller and Modigliani (1961) suggested that if management’ s expectation of

future earnings affects their decisions about current dividend payouts, then
changes in dividends would convey information to the market about future
earnings. Dividends can be used as a signal of future cash-flow (Bhattacharya,
1979). Alternatively, dividends provide information about earnings as an
explanation of the sources and uses of funds (Miller and Rock, 1985). Both
these hypotheses argue that unanticipated dividend changes should be
accompanied by stock price changes in the same direction. The signaling
hypothesis suggest that bond and stock returns should be positively correlated;
the signal provides information regarding the firm as a whole and,
consequently, bond and stock prices will move in the same direction depending
on the signal. Alternatively, the wealth transfer hypothesis suggests that bond
and stock value changes should be negatively correlated. Ignoring any dead-
weight losses (transaction costs), a wealth transfer is a zero-sum game; any
gains to shareholders must come at the expense of bondholders and vice-versa.
In summary, the signaling and wealth expropriation hypotheses have

3
implications about the impact of a dividend changes on both stock and bond
returns.

It is a well documented that share prices react positively to the dividend

changes [see Aharony and Swary (1980), Asquith and Mullins (1983),
Michaely et al (1995)]. As mentioned earlier, the major potential explanations
of the positive stock returns on dividend increases are signaling and bondholder
wealth expropriation. Aharony and Swary (1980) showed that equity share
returns at the time of dividend changes are significant even after controlling
them for simultaneous earnings announcements. Asquith and Mullins (1983)
reported a significant two-day abnormal return of 3.7%. Michaely et al (1995)
focused on extreme changes in dividend policy like dividend initiations and
omissions. Their research showed that the market reacts quite severely to those
announcements (3.4% for dividend initiations and -7.0% for dividend omissions
for a three-day window). It seems that the market has an asymmetric response
to dividend increases and decreases (and for initiations and omissions), which
implies that lowering dividends carries more informational content than
increasing dividends, perhaps because reductions are more unusual, or because
reductions are of greater magnitude. Michaely et al (1995) examined this issue
and found that when they controlled for the change in yield, the announcement
of an omission had a larger impact on prices than did an announcement of an
initiation. The positive stock price reaction is consistent with managers
knowing more than outside shareholders, and dividends changes providing
some information on future cash flows [See Bhattacharya (1979) and Miller and
Rock (1985)].

But there is not much empirical support for the hypothesized relation between
dividend changes and future earnings. Healy and Palepu’ s (1988) show that
firms that initiate (omit) dividends have significant increases (decreases) in
their annual earnings for at least one year before the change and in the year of
change. Benartzi et al (1997) examine the association between dividend
changes and future changes in earnings, using several definitions of earnings

4
innovations for a large number of firms and events over the period 1979-1991
and. They quantify earnings changes relative to the adjusted industry average
earnings changes. They adjusted industry average changes in earnings for
earnings momentum and for mean reversion in earnings. Like Healy and Palepu
(1988), Benartzi et al (1997) also find a clear pattern of earnings increase in the
two years following the dividend cut but not there after.

There are some studies examining the bondholder- shareholder conflict in the
context of dividend changes. Handjinicolaou and Kalay (1984) study the
consequence of dividend-change announcements on both share and debenture
prices. If dividend changes are driven by stockholders’ desire to extort wealth
from debt-holders, then an increase in dividends should have a positive impact
on stock prices (which is well acknowledged), and a negative impact on bond
prices. The reverse should be true for dividend decreases. The alternative
hypothesis, that dividends are a consequence of asymmetric information or that
they resolve free cash flow problems, implies that bond prices should move in
the same direction as equity prices. Handjinicolaou and Kalay (1984) found that
bond prices dropped significantly at the announcement of dividend decreases,
and did not change significantly at dividend-increase announcements. These
results do not lend support to the wealth expropriation hypothesis. In contrast
Dhillon and Johnson (1994) find evidence supporting the wealth transfer
hypothesis for large dividend changes.

Myers (1977) and Jensen and Meckling (1976) suggested that both shareholders
and bondholders may apriori agree on restricting dividends. Indeed, most bond
covenants contain constraints that limit both investments and debt-financed
dividends. Kalay (1982) examined these constraints and found that firms held
significantly more cash (or cash equivalents) than the minimum they needed to
hold, according to the bond covenants. We can interpret Kalay’ s finding as a
reverse wealth transfer. That is, if debt were priced under the assumption that
only the minimum cash would be held by the corporation, then a positive
reservoir would increase the market value of debt at the expense of

5
equityholders. In hindsight, this is not too surprising. We should not expect that
large, established firms, which are likely to have to come back to the well and
seek more debt financing at some point in the future, are going to relinquish
their reputation for a small gain at the expense of bondholders. We can readily
see how a one-time wealth transfer from existing bondholders to shareholders
may result in a long-term loss because of the increase in the cost of capital.
When would the problem arise? In precisely those cases where there is a great
probability that the firm’ s time horizon is short, e.g., the firm is in financial
distress, or is about to be taken private. DeAngelo and DeAngelo (1990) found
evidence that was consistent with this assertion. They showed that firms in
financial distress were reluctant to cut their dividends. In these cases, not
cutting dividends may constitute a significant wealth transfer from debtholders
to equityholders.

The following Table 1 summarizes the empirical implications of the models

discussed above. It is evident from the table that an analysis of bond valuation
will only provide insight to differentiate between the models as the
hypothesized sign of valuation change varies in the case of bond prices.

Table 1. Dividend Theories: Hypothesized Market Behaviour

Signaling theory Wealth transfer

Event Equity Bond Equity Bond
Dividend Increase + + + -
Dividend Decrease - - - +

3. METHODOLOGY

3.1 Sample Identification & Selection

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The database of daily bond prices available on the Stock Exchange, Mumbai
(BSE) website (www.bseindia.com) is used. The meeting of the board of
directors in which the dividend is declared is regarded as a dividend distribution
event. The relevant board meeting dates are drawn from the BSE daily
bulletins. The data on percentage of dividend as made available in the
capitaline 2000 database is utilized. The study relates to a 5-year time period
viz. from financial year 1997-98 to financial year 2001-02. Although bond
prices are reported on daily basis, the available series contain a number of
missing values due to non-trading. Further, the daily return calculated from this
series may lead to erroneous conclusions due to scanty trading of debt
instrument. Therefore, closing month-end prices have been used for analysis.
For the companies, which have issued more than one debt instrument in the
market the debt security, which is most frequently traded on the exchange has
been selected.

Since the board of directors usually consider the annual results and declare the
dividend in the same meeting, it becomes imperative to address the issue of
simultaneous consideration of earnings and dividend. However more often, the
companies declare their unaudited results immediately on completion of
financial year and latter in the board meeting they are formally taken on record
and the dividend is declared. As such the earnings are known before the date of
board meeting and only extra information available is earnings appropriation
through dividend declaration. Moreover due to announcement of quarterly
results, the surprise value of annual announcement has reduced considerably.

The sample selection criteria are described below:

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 1. Board meeting date for dividend announcement should be available in
the BSE daily bulletins and the data on percentage of dividend should
be available in the capitaline 2000 database.

2. The bond and share prices should available for the 6 months starting
from -4 to +1

3. The dividend increase sample includes dividend increases of 5% or

more. We have included an initiation of the dividend with a minimum
5%.

4. The dividend decrease sample includes dividend decreases of 5% or

more. We have included omissions of the dividend from a minimum
payment 5% in the previous year.

5. The sample for no change in dividend includes firms with a positive

dividend history and those, which have declared same dividend
(percentage) in the current year.

3.2 Sample Description

During this period 1997-02, we have identified 60 announcements matching the

selection criteria. The Table 2 shows yearly data on number of companies in the
sample categorized into three groups viz. dividend increase, dividend decrease
and no change in dividend. Though the number of firms in the dividend
increase and decrease sample is more or less same, the sample for no changes in
dividend category has more firms.

Table 2: No. of Companies in Increase, Decrease and No Change in Dividend Category

No Change in
Year Dividend Increase Dividend Decrease
Dividend
1997-98 4 2 9
1998-99 5 6 8
1999-00 3 4 9
2000-01 2 1 4

8
 2001-02 1 1 1
Total 15 14 31

Table 3 shows averages, standard deviation, variance, range, minimum and

maximum value of changes in dividend. The variable under consideration is a
naï ve change in dividend rate. The magnitude of change is more in case of
dividend decrease compared to dividend increase. Variability is also high in the
same category.

Table 3: Details on Changes in Dividend for Sample Companies

Dividend Dividend No Change in

Increase Decrease Dividend
Mean 8.70 -19.61 0.00
Median 5.00 -18.75 0.00
Mode 5.00 -15.00 0.00
Standard Deviation 4.89 11.38 0.00
Variance 23.92 129.47 0.00
Range 15.00 45.00 0.00
Minimum 5.00 -50.00 0.00
Maximum 20.00 -5.00 0.00
Count 15 14 31

3.3 Methodology

This sub-section describes the methodology followed in the analysis of stock

and bond returns. For the purpose of study, abnormal bond returns and
abnormal stock returns have been calculated around the dividend distribution
announcement.

A. Calculation of Abnormal Bond return

Monthly return for bond is calculated using Equation

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BRi,t = (Pi,t – Pi,t-1)/ Pi,t-1 …….……………………………………………(1)

BRi,t is defied as the returns on bond i for the month t

Pi,t : Price of bond i at the end of month t

Pi,t-1 : Price of bond i at the end of earlier month (t-1)

Monthly return for I Bex is calculated using Equation (2)

RIBext = (I Bext-I Bext-1)/I Bexi,t ……………..……………………….. (2)

I Bext: I Bex at the end of month t

I Bext-1: I Bex at the month of t-1

I Bex is the bond index developed by ICICI.

Abnormal bond returns are calculated using mean adjusted return model to
account for changes in the term structure [methodology developed by
Handjinicolaou and Kalay, 1984]. Bond prices are available on BSE as the
principle plus accrued interest. Hence to account for changes in the bond
returns related to shifts in term structure, IBEX (Total Return Index) developed
by ICICI, is used as the benchmark bond index. We have calculated Premium
Monthly Bond Return (PBR) for bond i; during month t as bond’ s monthly
return (BRi) minus return on the IBEX in the same month.

PBRi,t = BRi,t –RIBEXt ………………………………..….…………………(3)

The mean Expected Bond Return (EBR) for a bond; in the announcement
month is equal to the average PBR for the previous 3 months.

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 −1
EBRi ,t = ∑ PBR
t = −3
i ,t 3 …………………………..…………….………….. (4)

After calculating the expected return, the Abnormal Bond Return (ABR) for
bond i in month t (event month) is calculated as follows.

ABRi,t = PBRi,t - EBRi,t .…………………..…………...……………….(5)

Similarly, Abnormal Bond Return (ABR) in the month t+1 is also calculated as
follows.

ABRi,t+1= PBRi,t+1 – EBRi,t ……………………………………………(6)

Mean, median and ‘ t-value’ of abnormal bond returns for all the events in each
case viz. dividend increase, decrease and no change is calculated using standard
formulae.

B. Calculation of Abnormal stock return

The standard market-adjusted model for the calculation of abnormal stock

return has been used. The abnormal return is defined as the return of the stock
for the month less the return of the BSE Sensex for the corresponding month.

ARi,t = Ri,t – Rm,t ………………………………………………………………………………………………..(7)

ARi,t = Abnormal return on security of firm i for the period t

Ri,t = return on security of firm i for the period t

Rm,t = return on BSE Sensex for the period t

The statistical significance is arrived at using t-stastic calculated on the basis of

the cross-sectional standard error. The proportion of firms with positive
abnormal returns is reported additionally to verify whether the results are driven
by outliers.

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4. RESULTS

The results of the analysis have been presented in Table 4 and Table 5 for the bond prices
and stock prices, respectively.

Table 4. Average Abnormal Returns (%) for the Bonds and their t-values

Month Mean Median Prop + t-value

Dividend Increase
0 0.03 0.02 0.73 2.19*
1 0.00 -0.01 0.47 -0.28
No Changes in Dividend
0 0.01 0.02 0.68 1.31
1 0.02 0.02 0.74 1.90
Dividend Decrease
0 0.01 -0.01 0.40 0.49
1 0.00 0.00 0.53 0.47

*Significant at 0.05 % level

Table 5. Average Abnormal Returns (%) for the Stock and their T-Values

Month Mean Median Prop + t-value

Dividend Increase
0 0.07 0.04 0.8 2.86*
1 -0.04 -0.04 0.27 -1.21
No Changes in Dividend
0 -0.02 -0.02 1.20 0.45
1 0.05 0.01 -0.78 0.51
Dividend Decrease
0 -0.03 -0.05 0.27 -0.77
1 0.01 0.01 0.53 0.36

*Significant at 0.05 % level

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As shown in the above Table 4 and Table 5, in case of dividend increases,
abnormal returns are positive in the event-month and are statistically significant
at 0.5% level of significance. For instances of dividend decreases, abnormal
return is almost nil. The apparent reason for an insignificant reaction to the
dividend decreases may be the market expectation of such an announcement.
Quarterly results announcements are possibly making the surprise value of
dividend decrease announcement immaterial. In the event of no change in
dividend, abnormal returns are very low. In the month subsequent to the event,
no considerable abnormal returns are observed.

5. CONCLUSIONS

It is found that investors in bond market react positively in the event of increase
in dividend. This is characterized by a positive abnormal return in the month of
dividend increase. Whenever there is a decrease in dividend or the dividends
remain constant, abnormal bond returns in the month is not statistically
different from zero. Further by analyzing the equity valuations for this sample,
it is observed that the share price reaction to dividend changes as reported in
literature holds. Though it is reported in some of the studies that the reaction to
dividend decreases is significant, the present analysis shows that it not
statistically significant. However, the market has reacted positively to dividend
increases. Therefore, investor behavior in Indian bond market is consistent
with the signaling hypothesis.

One of the limitations of the study is small sample size due to the non-
availability of traded bond prices. The power of the analysis may be poor, as
scanty trading of the bonds has led us to carry out the analysis with monthly
prices.

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 APPENDIX
Table 6: Increase in Dividend- Names of Companies, Financial Year, Announcement
Month and Quantum

Company Name Year End Event Month Current Dividend % Previous Dividend % Change

1 Apollo Tyres Ltd. March-00 May-00 48 40 8

2 Deepak Fertilizers Ltd. March-98 Jun-98 15 0 15

3 Finolex industries Ltd. March-99 Jul-99 12.5 0 12.5

4 Indian Rayon & Inds. Ltd. March-97 May-97 67.5 62.5 5

5 Larsen & Toubro Ltd. March-98 Jun-98 65 60 5

6 Mahindra & Mahindra Ltd. March-98 Jun-98 55 50 5

7 Mahindra & Mahindra Ltd. March-97 Jun-97 50 45 5

8 Nirma Ltd. March-98 May-99 30 25 5

9 Sterlite Industries (I) Ltd. March-98 Sep-98 85 80 5

10 Sterlite Industries (I) Ltd. March-99 Aug-99 100 85 15

11 Sterlite Industries (I) Ltd. March-00 Jul-00 110 100 10

12 Tata Iron & Steel Co. Ltd. March-01 Jun-01 50 40 10

13 Tata Motors Ltd. March-97 May-97 80 60 20

14 Thirumalai Chemicals Ltd. March-97 Jun-97 40 35 5

15 United Phosphorus Ltd. March-99 May-99 35 30 5

14
 Table 7: Decrease in Dividend- Names of Companies, Financial Year, Announcement
Month and Quantum

Company Name Year End Event Month Current Dividend % Previous Dividend % Change

1 Bharat Earth Movers Ltd. March-99 Jul-99 0 20 -20

2 DCW (NC-B) March-98 Jul-97 20 25 -5

3 DCW (NC-B) March-97 Jul-98 0 20 -20

4 Gabriel India Ltd. March-98 Jul-98 25 50 -25

5 Gabriel India Ltd. March-99 Jul-99 10 25 -15

Indian Petrochemicals
6 Corpn. Ltd. March-99 May-99 10 40 -30

7 Indian Rayon & Inds. Ltd. March-98 May-98 50 67.5 -17.5

8 Tata Chemicals Ltd. March-99 May-99 50 65 -15

9 Tata Iron & Steel Co. Ltd. March-98 May-98 40 45 -5

10 Tata Motors Ltd. March-98 Jun-98 55 80 -25

11 Textool Co. Ltd. March-97 Jun-98 0 50 -50

12 Torrent Cables Ltd. March-97 Jun-97 0 22 -22

13 Videocon International Ltd. March-00 Aug-00 20 35 -15

14 Videocon International Ltd. March-01 Jul-01 10 20 -10

15
 Table 8: No Change in Dividend- Names of Companies, Financial Year and
Announcement Month

Company Name Year End Event Month Current Dividend % Previous Dividend % Change

1 Apollo Tyres Ltd. March-98 Jun-97 40 40 0

2 Apollo Tyres Ltd. March-99 Jun-98 40 40 0

3 Apollo Tyres Ltd. March-97 May-99 40 40 0

Gujarat Narmada Valley

4 Fertilizers Co. Ltd. March-97 May-97 22 22 0

Gujarat Narmada Valley

5 Fertilizers Co. Ltd. March-98 Jun-98 22 22 0

Gujarat Narmada Valley

6 Fertilizers Co. Ltd. March-99 May-99 22 22 0

7 Herbertsons Ltd. March-97 Aug-97 25 25 0

8 Herbertsons Ltd. March-98 Oct-98 25 25 0

9 Herbertsons Ltd. March-99 Jul-99 25 25 0

Indian Petrochemicals
10 Corpn. Ltd. March-97 May-97 40 40 0

Indian Petrochemicals
11 Corpn. Ltd. March-98 May-98 40 40 0

12 Jindal Iron & Steel CoLtd March-97 Aug-97 35 35 0

13 Jindal Iron & Steel CoLtd March-00 Sep-00 10 10 0

14 Larsen & Toubro Ltd. March-99 May-99 65 65 0

15 Larsen & Toubro Ltd. March-00 May-00 65 65 0

16
16 Larsen & Toubro Ltd. March-01 May-01 65 65 0

Lupin Laboratories Ltd.

17 [Merged] March-98 Aug-98 25 25 0

18 Mahindra & Mahindra Ltd. March-99 May-99 55 55 0

19 Nirma Ltd. March-99 May-99 30 30 0

20 Sterlite Industries (I) Ltd. March-97 Sep-97 80 80 0

21 Tata Chemicals Ltd. March-97 Aug-97 65 65 0

22 Tata Chemicals Ltd. March-98 Jun-98 65 65 0

23 Tata Chemicals Ltd. March-00 May-00 50 50 0

24 Tata Iron & Steel Co. Ltd. March-97 May-97 45 45 0

25 Tata Iron & Steel Co. Ltd. March-99 May-99 40 40 0

26 Tata Iron & Steel Co. Ltd. March-00 May-00 40 40 0

27 Thirumalai ChemicalsLtd. March-98 Jun-98 40 40 0

28 Thirumalai ChemicalsLtd. March-99 Jun-99 40 40 0

29 United Phosphorus Ltd. March-97 Jun-97 30 30 0

30 United Phosphorus Ltd. March-98 Jun-98 30 30 0

31 Videocon International Ltd. March-99 Jul-99 35 35 0

17
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Aharony J. and I. Swary (1980), “Quarterly Dividend and Earnings

Announcements and Stockholders’ Returns: An Empirical Analysis,” Journal of
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Asquith and Mullins (1983), “The Impact of Initiating Dividend Payments on

Shareholders’ Wealth,” Journal of Business, 56 (1), 77-96.

Benartzi et al (1997), “Do changes in dividends signal the future or the past?,”
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Bhattacharya A. (1979), “Imperfect Information, Dividend Policy, and `The

Bird In The Hand’ Fallacy,” Bell Journal of Economics, 10 (1), 259-270.

DeAngelo and DeAngelo (1990), “Dividend Policy and Financial Distress: An

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Handjinicolaou G. and A. Kalay (1984), “Wealth Redistributions or Changes in

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Jensen and Meckling (1976), “Theory of the Firm: Managerial Behavior,

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Kalay (1982), “The Ex-dividend Day Behavior of Stock Prices: A Re-
examination of the Clientele Effect,” Journal of Finance, 37, 1059-1070.

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Author Profile

Prof Varadraj B Bapat qualified as Chartered Accountant with all India Rank in
May 1995. . He is pursuing research for Ph.D. on Indian debt market at SJM
SOM, IIT(B).He visited Cornell University, NY, USA in April 2004 for making
presentations and for advanced studies in portfolio management. Presently he is
Vice-Principal of S. K. Somaiya College of Arts, Science and Commerce at
Vidyavihar, Mumbai-400077

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