Worries over a global recession, the nationalisation of major banks, the unwinding of leveraged players and the supplanting of cash dividends for stock dividends have combined to haunt the market since late last year.
Although the market has not seen another drop to match the precipitous fall of late 2008, implied dividends have continued to fall. 2010 Eurostoxx 50 dividend swaps were trading at 56.2 points by early morning today, according to Barclays Capital. This is down from 69.4 points on January 1 - a level that itself was seen by many analysts as unrealistically low.
According to Long, the current level of 2010 Eurostoxx 50 implied dividends effectively prices in a halt to bank, insurance and car sector dividends, in addition to a 35% cut elsewhere. "It's beyond extreme at this stage - it's unprecedented," he said.
Longer maturities have also fared badly. On January 1, 2015, Eurostoxx 50 dividend swaps were at 74.9 points. By early morning today, this had lessened to 62 points, according to Barclays Capital.
Dealers are structurally long dividends due to knock-in put options contained in popular structured products such as auto-callables and reverse convertibles. For investors, this means that if the underlying equities fall below a certain level, the products are redeemed in shares. To delta-hedge this feature, dealers need to hold more of the underlying equities as the market falls - so increasing their dividend exposures.
Through a combination of these exposures and other single-stock business, most banks are long dividends on a net basis. Analysts estimate there is as much as $100 million of exposure throughout the dealer community for each index-point move in implied dividends.
Dividend exposures were a driving factor for many hefty equity derivatives losses at major dealers during 2008. But many of these exposures are already heavily marked down, said one London-based structured products head at a large US dealer.
In recent years, banks have pounced on methods of laying off dividend risk with sophisticated investors, such as hedge funds. Many of these players - including some of the biggest names in the global hedge fund industry - took advantage of the opportunity to purchase longer-dated dividends at a discount.
"Many hedge funds had bought very long-dated dividends. These guys had 10-year dividends in their books, so their mark-to-markets must be horrible," said the London-based structured products head.
Meanwhile, liquidity in dividend swaps has improved since implied dividends shrunk late last year, according to banks active in the market. Dealers say market dislocation is grabbing the interest of some hedge funds that have been otherwise inactive in the dividend market and, increasingly, institutional investors.
"We're seeing some banks reduce their exposure as well as unwinding activity from hedge funds. But there are players out there with money to invest and they are trying to capitalise on those markets that have been pushed to extreme levels," said Alastair Beattie, a managing director in the hedge fund group at Société Générale in London.
Some of these investors are engaging in steepener trades by selling short-dated dividends while investing in longer-dated dividends, he added. By doing this, they are effectively taking the view that dividend levels will improve with an economic recovery over the next few years. Increasing amounts of investors are also trading options on dividends, he added.
With dividends trading as distressed assets, a greater diversity of bank clients has entered the market, dealers report. "There's greater breadth to the client base, which ultimately is a positive development for everyone since it increases liquidity," said Beattie.
Efforts to take dividends to a broader array of market players have also been assisted by Frankfurt-based derivatives exchange Eurex's launch of dividend futures on the Eurostoxx 50 in June 2008.
Providing an exposure that mimics dividend swaps, the products appeal to market participants that are unable or unwilling to trade over-the-counter derivatives. This seems to have had some success - a record 220,000 contracts were traded on the exchange during February. This is an increase of 306% over the previous record month of December last year, when 71,808 contracts were traded in the midst of market upheaval.