The Influence of Credit Scores on Dividend Policy: Evidence from the Korean Market

Abstract

The paper investigates the mechanism through which corporate credit ratings affect dividend payments by decomposing the mean difference of dividends into a part that is explained by the determinants of dividends and a residual part that is contributed by the pure credit group effect, in the framework of the traditional dividend model of Fama and French (2001). Historically, better credit rated firms have shown consistently higher propensity to pay dividends especially during the economic crisis period. According to the counter-factual decomposition technique of Jann (2008), better rated firms are more responsive to the firm characteristics that have positive impact on dividends and poor rated firms are more responsive to the negative dividend predictors. As a result, good (bad) credit ratings make corporate managers become more bold (timid) in their dividend payments and they tend to pay more (less) dividends than what their firm characteristics prescribe. The degree of information asymmetry increases for the poor group firms during crisis periods and they attempt to reserve more cash in preparation for future investments. The decomposition results suggest that the credit group effect can potentially exceed the effect of firm characteristics because firms of different credit ratings can respond to the very same firm characteristics in a different manner.