Equity derivatives: Swapping dates earns dividends

Dividend swaps have become one of the biggest money-spinners for investors using volatility arbitrage and long/short equity strategies, earning many hundreds of millions of dollars, say equity derivative bankers.

The growth in dividend payouts has been a key factor but dividend swap volumes have also been boosted by investors using them as a proxy inflation hedge.

Dividend options, a relatively new product, have yet to take off, but bankers expect volumes to grow as the market develops.

"The growth in dividend payouts in recent years has been phenomenal," says Dixit Joshi, managing director at Barclays Capital. "In some indices, dividend yields are multiples of what they were a few years ago, as companies that have built up big cash reserves seek to return some of that to shareholders."

The increase in dividend payouts has created opportunities for investors. "Investors are finding it very attractive to use dividend swaps to monetize their forward dividend payments," says Joshi. "It allows them to crystallize future returns upfront, so that the money can be invested in something else."

For now, activity in the dividend swap market has, however, concentrated around shorter dates, a fact that has created opportunities further along the curve.

According to Barclays Capital, the EuroStoxx50 dividend swap curve is currently implying negligible dividend growth of less than 1% annually between 2010 and 2016, which is highly unlikely.

From 1900 to date, the average geometric annual dividend growth rate over six-year rolling periods in the US is 4.4%, while in Germany the same number is 4.5% from 1973 to date. In the 1945-to-date period, when US dividend growth over any six-year period has never been negative, the annual geometric average growth has been 5.6%.

The reason for the low discount rate from 2010 onwards, according to Barclays Capital, is largely that the shorter dates in the market are much more actively traded, as investors have greater confidence in their views and are more happy to hold their swaps until maturity if necessary to realize their full value. By contrast, the back dates tend to languish because of a lack of players willing to take up the supply of notes from structuring desks.

Investors with confidence in European growth prospects can profit from the anomalously low implied dividend growth rates, by going long on long-dated Stoxx50 dividend swaps, or by executing swap curve steepeners, by shorting values in the 2010 area to buy the longer dates.