Coronavirus: Dividend futures – the Nostradamus trade

Most European banks have indicated that they will suspend dividend payments after the Bank of England followed the European Central Bank in discouraging payouts to shareholders while the coronavirus crisis rages.

The list of non-bank companies suspending their dividends is also growing, with Goldman Sachs predicting a 25{a87f602f9b65d268d2531d6307ed39cfde24e475374069973d0be7fc923da513} fall in payouts by S&P 500 index members this year – a forecast that balances payments already made with a 38{a87f602f9b65d268d2531d6307ed39cfde24e475374069973d0be7fc923da513} fall for the last nine months of 2020.

Other analysts expect a fall in dividend payments from European companies that may be close to a decline in earnings of around 50{a87f602f9b65d268d2531d6307ed39cfde24e475374069973d0be7fc923da513}.

Global dividend payments rose by 3.5{a87f602f9b65d268d2531d6307ed39cfde24e475374069973d0be7fc923da513} last year to a record total of the equivalent of $1.43 trillion, according to a study released by Janus Henderson in February, which noted that underlying growth compared with 2018 was 5.4{a87f602f9b65d268d2531d6307ed39cfde24e475374069973d0be7fc923da513} before allowing for the effect of strength in the US dollar.

The US accounted for the biggest proportion of this, with dividend payouts of $490.8 billion. Dividends from European companies ex-UK were down slightly in dollar terms at $251.4 billion, but after adjusting for exchange rate movements underlying growth was at 3.8{a87f602f9b65d268d2531d6307ed39cfde24e475374069973d0be7fc923da513}.

Janus Henderson pointed out that expectations for company earnings growth were modest but felt confident enough to assert that: “2020 is set to deliver the fifth consecutive year of record dividends”.

That was February and the situation in April looks starkly different, as the enormity of the economic impact of the Covid-19 crisis sinks in.

Pricing disparity

However, one expression of dividend expectations was depressed well before the severity of the global public health crisis became clear.

Dividend futures for the Euro Stoxx 50 index underperformed the spot market in late 2019 and the term structure for maturities beyond 2021 was downward sloping, pointing to lower expectations of payments by European companies in the years ahead, rather than the steady growth anticipated by many equity analysts.

So, did derivatives traders have a premonition of tough days ahead? The explanation for most of this pricing disparity is more prosaic.

Dividends form an important component of the risk that equity structured product dealers take on when they sell investments to retail and institutional customers. Bank dealers looking to hedge their exposure are generally net sellers of dividend futures, which can depress forward prices in longer maturities.

While Euro Stoxx 50 futures have become the main instrument for speculation on dividends in recent years, there may be some changes approaching in motivation among market participants 

The Euro Stoxx 50 is both one of the most widely used reference indices for equity structured product buyers in core markets in Asia and Europe, and also the index with the most liquid dividend futures.

Eurex launched Euro Stoxx dividend futures in June 2008 and listed derivatives activity quickly came to dominate trading volumes. US dividend trading was largely confined to over-the-counter derivatives until the impact of the Dodd-Frank reforms on capital charges for banks finally led to the launch of dividend futures by the CME in October 2015.

European dividend futures volumes are still far higher than their US equivalents, despite the disparity in size between underlying benchmark equity indices, and a slump in prices theoretically presents a range of investing opportunities at the moment.

As with so many apparent opportunities from market dislocation, the challenge is working out whether directional trades are worth the risk – and the margin exposure from any associated leverage – and whether hedged positions can be reliably risk managed.

The most dramatic move in Euro Stoxx 50 dividend futures in March came in the front two contracts for December 2020 and December 2021. Near-term contracts generally trade close to anticipated dividend levels because so many European companies pre-announce payment levels to shareholders, before longer dated futures prices fall to reflect the flow of selling by structured product dealers.

Both of the two front contracts traded at around 120 dividend points throughout January and February but had collapsed to 50 by the start of April after dividend suspensions were announced.

The December 2025 contract had been steady at around 110 for the first two months of the year but was at 68 in early April, while the longest dated December 2029 contract was just under 100 for most of January and February before also settling at 68 by the start of April.

Investing opportunity

A simple directional bet on a recovery in dividend payments after a recovery from the economic impact of the coronavirus is one potential investing opportunity. Another possible trade is to position for a return to the traditional downward slope in Euro Stoxx 50 dividend futures. That implies a wager that structured product sales will recover along with broader equity markets, increasing the flow of dividend futures sales in longer maturities by derivatives dealers from banks (although, confusingly, sharp underlying index falls could temporarily spur renewed bank hedging sales).

It also implies a bet on the speed at which companies in Europe resume payments of dividends, giving a boost to shorter dated futures contracts.

S&P 500 dividend futures on the CME, which are largely unaffected by flows from structured product offsetting, currently indicate expectations about payments that are more in line with commonsense.

At the start of the year the curve was mildly upward sloping, reflecting anticipation of slow but continued growth in dividend payments by US companies. After flattening in early March, the futures curve by early April reflected expectations of a fall in dividend payments until the end of next year, followed by a recovery in longer maturities.

While Euro Stoxx 50 futures have become the main instrument for speculation on dividends in recent years, because of their superior liquidity, there may be some changes approaching in motivation among market participants.

Along with their dividends, banks are rapidly cancelling their plans to pay bonuses in the near term. So while their peers at hedge funds and other investors may be tempted to play the dividend futures curve for a profit, the traders left marooned at banks may wonder whether there is much point in helping to keep the market functional.

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