Dividend futures in the new Covid-19 environment

This earnings season will look very different to prior years as the economic impact of the pandemic disrupts dividends. Investors are turning to dividend futures to hedge or express views on the US dividend market.

Firmly in earnings season, with pretty much every S&P 500 company reporting between now and the beginning of May, earnings will be scrutinised more closely amid economic distortions. Some companies may be giving earnings warning, others making changes or cutting dividends and a few providing forward guidance for the next quarter.  

With more than 2751 firms, over 60% of the weighting of the S&P 500 Index, due to report earnings in the next two weeks, this may be an opportune time to hedge or express views on the US dividend market using the S&P 500 Annual Dividend Futures at CME.

Looking back, Q1 2020 S&P 500 dividends set a record, paying USD 127.0 billion, an increase of 9.6% to USD 15.32 per share, up from Q1 2019’s $117.3 billion.2 The pre-Covid-19 2020 dividend payment forecast, predicted the year 2020 to set a new payment record, increasing in the low 9% range, with the potential for a return to double digits as last seen in 2015 (10.001%).

But March announcements revised downward, as 13 companies announced cuts, with 10 of them being suspensions, with a total forward impact of USD 13.9 billion or -2.6%.  More cuts are expected as can be imagined.  

April 9 saw SPDJI3 announce that indicated dividend net changes of $38.7 billion in the S&P 500, when big-banks and General Electric reduced their payments.  Given the uncertainties around the U.S dividend in the coming months.

The S&P Dividend Index Future prices a bearish scenario…

As the coronavirus crisis drives companies across many sectors to conserve cash the S&P Dividend Index Future prices a bearish scenario.  From its height of 59 index points on February 19, 2020, and in light of the global pandemic, the market initially, on April 3, had envisaged a hard contraction in dividends; expecting them to fall to as low as 32 index points, and to not fully recover even by as late as 2029. This is depicted by the blue dashed line in Image 1 below.

During the equity market rally of mid-April, these expectations have rebounded quite significantly. Equities have rallied 25% since March 23 driven by the flattening of the new infections curve which has raised hopes that the pandemic peak may not be that far away, and as governments start to ponder exit-strategies from damaging shutdowns, there are hopes for a for a quick end of the economic quarantine and a subsequent V-shaped recovery. As we go into the earnings season, these positives change the previous outlook for dividends.

…but perhaps not as bearish as initially thought

Futures would suggest that S&P 500 dividends are in better shape than the market expected them to be last week. We are now right back to expecting the same level of dividends in 2030 as the market expected, when it was at the record high on February 19th. As shown by the red line in Image 1. Even by this estimate, in the interim period between now and 2030, dividend recovery will likely be anemic, as it relates to sectors such as consumer discretionary stocks, financial stocks, energy company stocks, materials etc. and will return less than the pre-Covid-19 projections.

Image 1

So why is this happening?

The S&P 500 has outperformed the expected dollar growth in dividends. This is seen when we compare S&P 500 Dividend future 5 years forward to the S&P 500 Index points. Here we see that the continuous 5 year ahead curve, the black line in Image 2, is where the market thinks the dividends will be in 5 years’ time, even before the crash, the expectation was that dividends would be stagnant. Updated predictions show that the expectation is the market would be paying out 54 dividend point instead of the high 50’s to 60’s which it had thought previously. Yet the S&P 500 index, as represented by the light blue line in image 2, has seen a steady increase and a healthy rebound from the recent crash.

Image 2

Based on this data, some market participants are predicting that the forward guidance for Q2 dividends will show a -30% to -40% growth rate and a 40%+ drop in dividends this year and next followed by a decent recovery.

The S&P 500 Annual Dividend Index Future curve shows front end sell off

This sentiment is reflected in the Annual S&P 500 Dividend Index Future (SDA) contracts where the front end of the curve has sold off since the index peak. Image 3 shows the term structure comparison between the beginning of the year (1/3/2020), the S&P 500 index peak (2/19/2020), the recent trough on 3/23/2020 and current for comparison.

Image 3

Source: CME Group using QuikStrike

S&P 500 Annual Dividend Futures Gain Traction

Dividend futures allow users the ability to hedge or express their view on the US dividend market, regardless of price movement in the S&P 500 Index. Given recent market developments with some companies announcing dividend cuts or suspensions, dividend futures have been an area of focus for the market.

The uncertainty regarding company cash flows has resulted in increased usage of dividend futures. Concerns about valuation risk and the chances for a related pullback might be addressed by considering dividend futures. One way to diversify a portfolio while protecting earnings can be achieved by buying dividend futures. This allows for a buyer to pay a discounted price now, for the potential of a full dividend payment in the future. It can also protect from a sudden shift in investor sentiment.

Uncleared margin rules is also a key consideration in employing such a strategy, since trading such listed and cleared derivates is a more capital efficient allocation of balance sheet than in the OTC swaps market where uncleared margin rules and higher initial margin requirements are in play.  

S&P500 Dividend Futures saw a record on Feb 20, 2020 with 23,116 contracts, $370M in dividend futures notional traded and is now at YTD ADV of 3.9k. As of last Wednesday, April 15 we have seen Open Interest (OI) climb to 156,261 contracts ($1.88B notional value), and a record 60 Large Open Interest Holders (LOIH). In notional terms the recent high was $2.2B on March 6, with 145,739 contracts traded, as shown by Image 4. This liquidity can provide an efficient tool to manage dividend projections.

Image 4

Source: CME Group

Based on the current crisis, it is very feasible that we will see a decline in the S&P 500’s dividend payout for 2020. The last time this occurred was in the aftermath of the financial crisis in 2008. Given this uncertainty average daily volume has notably grown with ADV this year averaging almost 4000 contacts which is up over 300% vs 2019 and with early April ADV of 4x. Both buyside and dealer participation have turned to CME’s S&P 500 dividend futures in lieu of OTC dividend swaps and this volume growth is shown in Image 5. Trading predominately occurs by BTIC or block, with 62% of ADV being traded via blocks in 2020 vs 38% on screen.

Image 5

Source: CME Group

The number of Dividend futures’ LOIH continue to set new records – the latest COT report (out Friday night for April 14) shows 60 LOIH, surpassing the previous record of 55. This represents an increase of 88% from a year ago and 8% from a month ago.

Image 6

Source: CME Group

Closing thoughts

The impact of Covid-19 on dividends will make this year’s earnings season look very different to previous years. There will no doubt be big, possibly long-term disruptions to earnings. Against this backdrop, some investors are looking at dividend futures to hedge and manage their dividend risk. Increased liquidity in the S&P Annual Dividend Index future with ADV of 3.9k contracts, OI of 156k contracts, a high of 60 LOIH’s, as well as recent record volume days is one indicator that these futures can provide an efficient tool to manage dividend projections.

References

  1. Source: Bloomberg. S&P 500 dividend calendar
  2. Source: SPDJI Press Release April 9, 2020: “S&P Dow Jones Indices Reports $5.5 Billion Decrease in U.S indicated Dividend Payments.” https://us.spindices.com/search/?ContentType=Announcement
  3. Ibid.

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