By now, most of us are familiar with the credit default swap, which is a derivative security that a bond investor may purchase as “insurance” against the bond issuer’s bankruptcy. If the bond issuer goes bankrupt, then the credit default swap issuer will pay the investor a pre-arranged amount, offsetting the investor’s losses on the bond. By the same token, if the bond issuer does not go bankrupt and continues to meet its obligations to pay interest and principal to the bond investor, then the credit default swap will expire worthless, and the party who issued the credit default swap will earn a profit. But either way, the bond investor will be paid, and thus inhabits a fairly risk-neutral position. The credit default swap market is one of the largest securities markets in the globe, and from the early 1990s until the end of 2007, expanded to a total of $62.2 trillion worth of nominal value.
In an era of low yielding bonds, many investors have switched over from holding bonds to holding equities. In fact, in today’s market, some equities offer yields that may exceed the yields available on bonds, and for that reason, have become increasingly attractive to investors. As I have highlighted in previous articles, the problem with dividends is that unlike interest or principal obligations, companies are free to cut dividends at will. In that sense, relying on equity dividends is a riskier means for an investor to secure a future income stream than relying on bond interest and principal payments. So this presents investors with a conundrum: accept a low yield on bonds in exchange for greater payment certainty, or go with higher income on equities, but live with some payment uncertainty. Well, what if you can’t live with payment uncertainty, but at the same time, cannot accept the prospects of holding low yielding bonds?
This conundrum is not necessary. I propose a new product: the dividend default swap. The way this product would work is almost exactly the same as a credit default swap, except it would apply to dividends, instead of interest and principal payments.
Here’s an example (completely hypothetical, I might add) of how the product might work. Alex, who is recently retired, owns 100,000 shares of stock in McDonald's (MCD), which now pays a quarterly dividend of 61 cents per share, which Alex uses to live on. Alex cannot abide the risk that McDonald's could slash its dividend in the future, so Alex approaches his friendly investment banker and buys a dividend default swap. Under the terms of the swap, Alex will pay the banker $5,000 today in exchange for which the banker promises, for the next year, to pay Alex a sum equal to ($61,000) minus (whatever dividends McDonald's pays on 100,000 shares over the course of the year). If McDonald's keeps its dividend at 61 cents per share, or raises its dividend, the swap expires worthless, Alex gets the cash flow he expected (plus any upside if McDonald's raises dividends), and the banker keeps the $5,000 premium Alex paid at the beginning of the year. If McDonald's cuts its dividend by half, Alex gets a sum of $30,500 from banker, plus the $30,500 worth of dividends from McDonald's. Regardless of what McDonald's does or does not do with its dividend, Alex is secure that his portfolio will provide him the cash flow he expects over the year. Obviously, though, the price of the swap will vary tremendously based on the likelihood of McDonald's slashing its dividend. In fact, the pricing on dividend default swaps could give other investors a window into just how risky a company’s dividend may be – which is similar to how investors gauge a bond issuer’s likelihood for going bankrupt.
Judging by the low yields on bonds, and the widely recognized risks to bond investors from rising inflation and rising interest rates, interest in equity yield is relatively high these days. But all that means is that more investors are at risk if companies decide to cut dividends in the future. It’s fair to judge that many investors would hedge this risk if they could, and that interest in products such as dividend default swaps could be high. Even if dividend default swaps were only half as popular as credit default swaps, you’re still talking about a potential $30 trillion dollar marketplace. Not a bad marketplace to participate in, if you’re an investment bank. And for pension funds and other investors which hold equities and which depend on steady income, products like dividend default swaps seem like a potentially useful tool to have available.
I am not aware of any issuer for dividend default swaps at this point, but I am speaking with bankers and will write a follow up article on whatever I learn that may be of interest to my faithful readers.
Disclosure: I am long MCD.