As positive results of the current round of U.S.-based banks stress tests were overshadowed by Brexit, the dividend investment community had been awaiting the results potentially impacting the dividends and stock prices of banking institutions for 2016. Stress testing is designed to determine whether a financial institution is capable of withstanding some type of economic downturn, making it a natural indicator of company health. So far, the Federal Reserve has indicated that all 33 tested banks have sufficient capital on reserve in order to weather losses in a recession. As a firm solely focused on divided growth investment solutions, Reality Shares is closely watching stress testing for its potential impact on dividends and the overall market dividend growth rate. Stress testing directly impacts dividends, as financial institutions failing stress testing are prevented from paying out dividends or any type of capital to their shareholders.
Stress testing began in the aftermath of the Great Recession as a result of the financial crisis that brought down and threatened several financial institutions including AIG, Countrywide Financial and Lehman Brothers. In its aftermath, the U.S. Federal Reserve created the Comprehensive Capital Analysis and Review to monitor financial institutions in the hopes of preventing any future bailouts. These tests have come to be known as CCAR or stress-tests, and today determine whether a company over $10 billion in assets can go through a sort of worst-case downturn scenario, weather such difficulty and survive. The results of the first part of the tests, determining whether banks have the capital to survive major losses in the event of a recession, were announced late last week with all 33 tested banks passing. The results of the second part, known as the qualitative portion of the test, will be announced later this week.
Delving Deeper into the Dividend Growth Investment Insights of Stress Testing
While banks might complain about the difficulty and cost of performing annual stress tests, the tests have provided valuable insight to investors and especially dividend growth investors. Banks seek to keep or increase their dividends even when it may be financially restrictive, as failing to do so reflects very poorly upon the company and its management. Also, being prevented from paying a dividend whatsoever seems unthinkable to most company management teams, as investors in companies under that much financial distress may choose to sell positions or even move to replace underperforming executives.
Bank balance sheets have only improved since the Great Recession, meaning if allowed by the Federal Reserve, many banks will be likely looking to increase their dividend. This historically has buoyed stock performance, as we have all seen the research showing that dividend growers significantly outpace non-dividend payers. Conversely, companies or banks that cut or eliminate dividends typically see selling pressure and have historically underperformed (Source: Ned Davis Research, Reality Shares Research, 1972-2015).
Supportive News for the Dividend Growth Rate?
With the successful tests announced in late June, it could mean that there is still much room for dividend growth in the financial sector, resulting in the potential for a positive impact to the overall market dividend growth rate. The two banks with perhaps the most potential to significantly grow their dividend are Bank of America and Citigroup. These also happen to be two of the most prominent banks in the country. Prior to the Great Recession, Bank of America (NYSE:BAC) paid a dividend of $0.64 per share. When factoring in its reverse stock split, Citigroup (NYSE:C) paid $5.40. More recently however, both banks have paid dividends as low as just $.01, largely stemming from their difficulties in passing annual stress tests.
Representatives from both banks have indicated optimism in passing stress tests this year. If this group of prominent banks is able to build on their successful stress tests and gain the approval to increase their dividend, overall market dividends could be positively impacted. As the financial sector is historically one of the largest payers of dividends in the S&P 500, the positive stress test results can have a much larger than expected impact the overall dividend growth rate.
15 of the 24 banks in the S&P 500 undergoing stress tests are paying dividends at or below pre-recessionary levels, meaning those that pass will potentially be able to grow their dividends.
Room for Dividend Growth in Financials
The financial sector currently only pays about 16.38% of the dividend in the S&P 500 today. On average, companies in the financial sector pay a dividend yield of about 2.17% (Source: S&P, May 2016). While these number are on par with the index average, the financial sector has previously paid as high as 30% of the S&P 500's dividend, indicating potential room for growth with the recent stress-test results. The dividend/buyback results and announcements will be released tomorrow.
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