Implied dividends sunk towards distressed levels from the end of the fourth quarter last year, after dealers scrambled to hedge long dividend exposures in the face of worsening dividend forecasts and the dearth of hedge funds willing to absorb long exposures. Dealers are inherently long dividends because of the bullish equity structured products they sell. But given the positive performance of equity markets and no big surprises in the earnings season, dealers' need to sell dividends has waned considerably.
"There has been a re-rating of dividends," said Simon Carter, the London-based head of equity derivatives flow research, Europe, at BNP Paribas. "Forced selling caused a massive dislocation between the performance of the equity market [and] the dividend market, and dividends were much more aggressively impacted. But the more recent alleviation of forced selling of long dividend positions by dealers and hedge funds, as well as less extreme market conditions, made participants realise just how big a discount implied dividends were trading at versus the underlying stock fundamentals. They got compressed much more than they should have done."
On January 9, 2010 Eurostoxx implied dividends traded at 71 points, only to slide to 54 on February 3 and 58 on March 13, according to Citi. It has since rallied to 74 as of May 11, a 37% rise from the low on February 3. Meanwhile 2011 implied dividends fell from 70 on January 9 to 51 on February 3, rising to 71 yesterday, while 2012 implied went from 69 on January 9 to 49 on February 3 before recovering to 73 on May 11.
The dividend rally is also being attributed to the recovery staged by the equity market. As stocks have climbed, dividends have followed suit. The Eurostoxx rose from 1969.52 on March 13 to 2433.59 on May 11, a surge of 23.5%, as 2010 dividends rose 27% for the same period. Dividends have a delta to the underlying equity market so implied dividends have tracked equity performance, says Gilles Dahan, head of derivatives trading, Europe, the Middle East and Africa, at Citi in London.
The consensus from market participants is that dividends have returned to fundamental levels but there is potential for dividends to rally further. "There is still reason to believe there is potentially more upside," says Dahan. "Dividends are still priced pessimistically; 2010 levels are still trading at a 40% discount to 2009. But potential dividend upside remains married to the sustained rally in equities. If the equity market recovery were to reverse, we might well see dividends turning south again as we did earlier this year."