Investors in the stock market are starting to realize what investors in the bond market have known for a long time – that the cash flows from dividends and the cash flows from the sale of an asset can be separated.
For years, investors in bonds have been stripping all the coupons off Treasury bonds and selling the resulting two bonds as distinct investments. Now investors in equity markets are starting to pursue similar tactics.
Investors in stocks today can use a variety of different derivatives tools to separate out dividends from the underlying stock and thus gain pure exposure to dividend cash flows. The market of the product, while still small (less than $1 billion in annual transactions to retail investors), is potentially enormous given the $20-trillion-plus size of the overall equity markets.
You can find an updated list of companies that recently announced changes in their payout policies, along with their ex-dividend dates, in our Dividend Payout Changes and Announcements tool.
Getting Pure Dividend Exposure
Many investors are purely focused on long-term total returns from equities. For these investors, a traditional stock portfolio works well. For investors looking to focus on the income produced by stocks, without having to worry about capital gains or losses, derivatives products focused on dividends can be valuable.
In particular, the use of derivatives can let an investor gain dividend exposure with lower capital investment and without the exposure to stock prices. These investors would likely be interested in having a long exposure to dividends. On the other side of the coin, some investors may be concerned about the risk of a dividend cut and its effect on an equity. For these investors, having short exposure to dividends can help to hedge risk.
Check out what the investors are currently most interested in by visiting our Most Watched Stocks Page.
Tools for Dividend Exposure
There are four basic tools that an investor can use to get exposure to a pure form of dividends: forwards, futures, options and swaps.
Forwards are a derivative where one investor agrees to buy an asset at a particular point in time in the future. For example, a one-year forward on General Electric would mean that an investor agrees to buy GE exactly one year from now.
Unlike an option, the holder of the forward has no choice here – they are contractually obligated to buy GE stock, regardless of what happens to the firm. This makes a forward cheaper than a comparable option since there is no choice on the part of the holder involved.
Forwards can be used to help capture exposure to dividends or to hedge dividend risk. For example, a combination of a long position in a stock and a short position in a forward creates long exposure to a firm’s dividend stream without significant equity exposure when hedged.
Forwards are a useful product in large part because they can be customized to the needs of the particular investor. The downside is that because they are individually customized, they do not typically trade through standardized exchanges, and they can be hard to unwind if an investor wants to get out of the trade partway through.
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Futures work very similarly to forwards, except they trade through exchanges. Just like a forward, a futures contract guarantees that the party that is long in the future will buy a particular product at a given point in time in the future. This makes them widely used in commodities, where companies producing and consuming certain products can use futures to lock in their needs at a given price. The same thing applies to equities. A one-year S&P futures contract would guarantee that the holder of the contract would buy the S&P proxy at a particular pre-set price one year in the future.
Just like with forwards, futures can be used to capture exposure to dividends or to hedge dividend risk. A long position in a futures contract offers the investor exposure to equity upside, with none of the risk of a dividend cut when paired with an equity short hedge.
Futures have the primary benefit of liquidity in comparison with forwards. Because futures are traded through exchanges, investors can easily get out of investments in the middle of their lives if needed.
Options are similar to forwards and futures, but they come with a choice for the investor. A call option gives the investor the right, but not the obligation, to buy a stock at a preset price, while a put option offers the right, but not the obligation, to sell a stock at a particular price.
The primary benefit for options, then, is their flexibility, though like futures they are also liquid and exchange-traded.
Options can be used to hedge dividend exposure or gain it. Long positions in options generally do not adjust the price of the option based on the dividends paid by the firm. (Special dividends are sometimes an exception.) For example, a $20 stock that pays $1 per year in dividends will fall to $19 in price due to the dividends if no other price changes occur. As a result, being long on a call option creates exposure to underlying changes in dividends, but carries none of the benefits of the dividend. This is important to keep in mind when considering the use of options in an investment strategy. Being long in a stock and short on an at-the-money call provides pure exposure to dividend payments as a result.
Learn how to use put options to increase yield by creating a synthetic dividend.
Dividend swaps are the most esoteric tool that can be used when trying to get exposure to dividends. A swap is a trade between two parties, usually involving “swapping” one set of payments for another. For example, a common swap involves trading a set of fixed payments based on a fixed interest rate in exchange for a set of payments that vary with the level of the Fed Funds rate or LIBOR. This is called a fixed-for-floating swap.
In a dividend swap, the purchaser of the swap agrees to pay a fixed dividend payment amount (or fixed leg) in exchange for the sum of all qualifying dividends during the period of the swap (the floating leg).This means that it is a bit like buying a stock – you pay the brokerage firm or bank a fixed amount in exchange for getting payments equal to dividends paid out by a firm over time.
Swaps have the advantage of providing pure exposure to dividends, and they do not cost the investor anything up front. The downside is that they typically are only available in large increments – often notional amounts of $100,000 to $1 million or more. Thus they are primarily of value to institutional investors. They are also illiquid compared to options and futures.
Want to know how you can secure your dividends using dividend swaps? Click here.
Which Product is Right for You?
Options and futures have been around for decades and became popular in the 1970s. Forwards and dividend swaps are more recent innovations that have really gained traction since 2000. The former two products are more liquid and more likely to be useful for retail investors as a result, while the latter two should really only be used by sophisticated investors.
Still, for any investor looking for pure dividend exposure, all of these tools can be potentially interesting choices.
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