For most of this decade, dividend swaps have been a mutually beneficial deal for structured product desks. For dealers, the swaps were a way to get dividend risk off their structured product books, while investors were only too happy to buy cheap exposure to dividends which, consensus said, were undervalued and would only increase.
The recent credit crisis and impending economic recession has called this assumption into question. “At the moment, the market is expecting dividend cuts of between 6-9% for 2008 and 2009 and of 2-3% for 2010, and only from 2010 do you see the market slowly pricing in a dividend increase,” said Francois-Xavier Louvet, managing director of equity derivatives arbitrage at Barclays Capital in London. As a result, the implied dividend swap curve has flattened dramatically.
But, despite the unfavourable outlook, dealers say investors are increasingly interested in the opportunities the asset class can offer. This is not because they believe managers will be reluctant to cut dividends that are attracting investors, but because dividend swaps provide a less volatile return that is not correlated to other major asset classes. Dividend swaps can also prove a useful inflation hedge, because, while equity performance tends to deteriorate as inflation increases, dividend returns tend to be more stable.
The steepening trade, which takes advantage of higher future dividend payments by selling near-term exposures and purchasing longer-term maturities, is proving particularly popular. “New entrants in the sector have predominantly focused on steepening trades, selling exposure on 2009 to 2011 maturities and buying exposure on maturities between 2014 and 2016,” said Emmanuel Dray, head of forward trading, Europe, at BNP Paribas in Paris, who believes the steepening position is a strong buy in the current flattened curve. “There is absolutely no evidence to suggest that the time of 5-10% implied annual dividend growth rates as registered in the past should be finished. There may be a dip for the next two years, but I am certain the 2014 dividends will be much higher than the market is currently implying.”
Other investors hope to pick up short-term bargains, in the expectation that not all companies will underperform as drastically as the market is pricing in. “Not every dividend paying company is in the same boat and the dispersion in earnings over the next 12 months is going to be magnificent,” said Nick Tranter, head of European equity derivatives flow sales at BNP Paribas in London.
Dray agreed. “A number of hedge funds have taken advantage of the flattening of the curve to buy some more near-term exposure to a select number of companies, which they believe will not cut their dividends in 2009 or 2010,” he said.
BNP Paribas has also seen considerable demand for more complicated options on dividend swaps, such as buying calls on dividend swaps or dividend yield swaps. A 2009 call on a dividend swap maturing in 2014, for example, gives an investor the right to buy at a fixed price (the strike) a dividend swap 2014 in December 2009, while a dividend yield swap 2014 will settle at the level of the dividend swap paid in 2014, divided by the spot of the Eurostoxx 50 index at the end of 2014, for example 3.80%. The latter expresses a view in terms of the payout ratio of Eurostoxx 50 stocks for the year 2014.
“It’s an evolutionary process,” said Alastair Beattie, managing director for the hedge fund group at Société Générale in London, of the innovation process. “There is a whole range of option strategies that can be applied on the back of these dividend swaps and, as time goes on, products will become more and more fine-tuned to give investors the exact exposure to dividends that they want.”
The increased interest has led Barclays to launch the dividend swap index family, designed to open the market to a wider range of investors. The indexes replicate the performance of investing in equity dividend swaps. The indexes are calculated for the Eurostoxx 50, the FTSE 100, the S&P 500 and the Nikkei 225, with tenors from two to five years. Each index reflects the return of entering into a forward starting dividend swap on an equity index, with the specific tenor on the third Friday of December of each year. The swap position runs for a year, after which the position is unwound and a new swap position with a new dividend level is initiated.
“It’s a similar approach to the one that is commonly adopted in the interest rate swap index methodology, but applied to the dividend swap market and with an annual, rather than a daily or monthly, roll because the swap has an annual maturity,” explained Waqas Samad, head of index products at Barclays Capital in London. “The aim was really to open up access to a wider range of investors than the more sophisticated, hedge fund type of investors who have dominated this market in the past,” he said.