Market.view

Uncharted waters

Feb 1st 2009
From Economist.com

An opportunity in the dividend-swap market

DIVIDENDS give shares much of their value. In theory, the price of a share should be equal to the value of all future discounted cashflows.

Of course, there is a big gap between theory and practice. Calculating future dividend payments is virtually impossible, and applying the right discount rate very tricky. Some companies pay no dividends at all, but clearly their shares have some value. And one can argue about how to fit share buy-backs into the calculations (not all shareholders benefit from them).

Despite all the provisos, the outlook for dividend payouts is clearly crucial to the prospects for the stockmarket. And if one key indicator is examined, that outlook is distinctly gloomy. According to Eamonn Long of Barclays Capital, the dividend-swap market is expecting European dividends to fall 40% over the 2008-2009 fiscal year and a further 40% in 2009-2010—or by two-thirds over two years. American dividends are expected to fall 25% in 2008-2009 and a further 6% in 2009-2010; in Japan, the declines are expected to be 32% and 35% over the same periods.

Dividend swaps arose from the creation of futures contracts on stockmarkets, some of which excluded dividend payments. Those leave one party to the contract with the risk of receiving future dividend payments—a risk that begs hedging.

Under a dividend swap, one party makes a fixed payment based on the market’s estimate of current dividends, and then receives the dividends that are actually paid out. The calculation involves a combination of dividends per share for each company, the total amount of shares in issue, and that company’s weight in the index.

For example, on January 29th, the Euro Stoxx 50 index closed just above 2292, and the market price of the dividend swap was 97, equivalent to a yield of just over 4% of the index. An investor who expected dividends to fall would elect to receive the fixed 97 payment; one who thought dividends would rise would elect to pay 97 and hope to make a gain by the end of the contract period.

In autumn of 2008, this market collapsed (see chart). Mr Long ascribes the sudden decline to a number of factors. First, rescue packages for the banking sector (a big dividend payer) often contained explicit or implicit requirements for dividends to be cut. Second, some companies may switch to paying scrip, or stock, dividends instead of cash (paper dividends do not count under the swap rules). Third, the deterioration in economic conditions would obviously cause a broad range of companies to reduce payouts. Fourth, hedge funds were big players in the dividend-swap market and were forced to cut all their positions last autumn.

The net result is that the market is pricing in a pretty severe outcome. American dividends more than halved between 1929 and 1931, but that was an extreme low; they have increased more than a hundredfold in nominal terms since then. According to Mr Long, the market is not expecting any dividend growth after 2010. Even in the depression, dividends more than doubled between 1931 and 1936. Figures from Britain, which date back to 1900, show that the biggest single fall in payouts was in 1919, when dividends fell 47%, but they more than doubled the following year.

So the outlook for dividends, as reflected in swap prices, is historically unprecedented. That suggests an investment opportunity. Either the swap market is wrong and dividends will be higher than forecast, or the equity market has yet to reflect all the bad news.

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