Dividend Risk Falling With Rates

“Food is an important part of a balanced diet.”

—Author Fran Lebowitz

Last December in the midst of a corporate credit meltdown, we penned an article on ETF.com, “Growing Risk In Dividend Focused ETFs,” where we warned how investors in dividend-focused funds could be at risk as overleveraged companies would go on a balance sheet diet lest they lose their investment-grade rating (so-called fallen-angel risk).

In the article, we posited that the Federal Reserve, having expressed early signals of a dovish pivot away from raising interest rates (a Fed “pause”), “would open a window for over-leveraged corporations to improve their balance sheets through lender-friendly capital decisions at the expense of shareholder-friendly activities.”

As stocks and corporate credit were selling off throughout the fourth quarter in 2018, the income-focused risk/reward was shifting from dividend-paying strategies to corporate credit.

Fed’s Dovish Pivot

Although we did not initially foresee the Fed pulling a 180-degree dovish turn throughout the first half of 2019, we were seeing the early onset of the Fed’s dovish pivot. That would turn Fed policy from head wind to tail wind, benefiting corporate lenders as the cost of credit for highly leveraged borrowers dropped throughout the first half of this year (Figure 1).

Figure 1: Lower Investment-Grade & High-Yield Credit Spreads Have Narrowed Throughout 2019

But it wasn’t just a dovish shift in Fed policy that explains the rally in lower investment-grade credit or the increased resiliency of the U.S. economy.

In a July 31, 2019 Bloomberg article, “BBB Companies Are Proving Safer Than They Seemed … ,” the authors cited research from Bank of America that “fallen angel” risk had largely dissipated as “the lowest-rated blue-company debt [proved] to be higher quality” than what was feared in 2018.

BBB-rated companies had indeed taken advantage of the window given by a newly dovish Fed to take “debt-friendly steps [such as] paying down borrowings and cutting payouts to shareholders.” BofA estimated that 12% of the investment-grade index and 20% of BBB-rated issuers (ex financials and utilities) have taken debt-friendly measures, much of them at the expense of equity shareholders.

Balance Sheet Diet

The BofA researchers viewed this level of lender-friendly activity well before the onset of a recession as “highly unusual,” suggesting that corporate America only goes on a diet when it no longer has access to the fridge. However, BofA’s observations on corporate balance sheet improvements confirmed what we had written last December:

“In a nutshell, Corporate America is going on a balance sheet ‘diet’ after having binged on share repurchases, dividend payouts, and mergers/acquisitions (M&A). If corporate finance officers stick to their New Year’s Resolution of a more disciplined capital diet (with the help of their personal trainers – the Rating Agencies), this course correction in capital allocation should favor credit holders over equity shareholders.”

We also affirmed Bloomberg Intelligence’s (BI) findings that highly leveraged companies still had time to de-lever:

“The good news is that corporate borrowers still have some time to strengthen their balance sheets while they remain profitable, assuming the global economy doesn’t fall into recession. According to BI Report, 90% of BBB-rated issuers are reporting positive operating cash flow with 50-75% of that cash flow spent on shareholder returns.”

So far in 2019, highly leveraged companies have “gotten religion,” taking proactive measures to avoid a rating downgrade now rather than later after an economic recession has already taken place.

Some Rejoice

Figure 2 displays the relative performance of the MSCI USA High Dividend Total Return Index versus the S&P 500 Index and the relative performance of the iBoxx BBB-rated Index versus the Bloomberg/Barclays US Treasury 7-10 Year Index.

Rather than showing absolute YTD performance of high dividend strategies and BBB credit, we are showing relative performance by neutralizing much of the market risks associated with equities and fixed income, respectively.

As a risk factor, high dividend strategies have lagged the broader market this year, while lower investment-grade corporate credit has handily outperformed U.S. Treasuries; lenders are enjoying the fruits of the corporate balance sheet diet; dividend recipients not so much.

Figure 2: Cumulative Log Excess Return YTD Through July 2019

Granted, it has not been a terrible year for dividend-paying strategies. They have still benefited from a strong U.S. market advance. However, it’s clear that credit investors have enjoyed greater “risk” compensation. Dividend recipients have faced the prospect of no dividend growth/dividend cuts.

Some might dismiss the high-dividend underperformance as style-specific given that “price”-driven strategies (i.e., value, yield) have underperformed “growth” this year. Indeed, “dividend growth” has outperformed “high dividend” (Figure 3).

Figure 3: ‘Dividend Growth’ Outperforming ‘High Dividend’ (YTD through 7/31/2019)

Low Vol Rides Lower Rates Higher

However, low volatility strategies have also performed well this year, on a market beta-adjusted basis (unusual given the strength in this year’s market advance). Low volatility has likely benefited from the large drop in interest rates this year, but high-dividend strategies should have also benefited from a combination of lower interest rates and narrower credit spreads. Yet high dividend has lagged most other smart beta strategies in 2019.

In our December article, we showed the portfolio-weighted credit rating exposures of the top 10 dividend-focused ETFs (based on AUM) tracked by ETF.com (Figure 4). We calculated the portfolio-weighted credit rating exposures based on the senior unsecured credit ratings assigned by Moody’s and S&P.

Figure 4: Credit Risk Exposures Of Dividend-Focused ETFs & The S&P 500 (12/13/2018)

Our point at the time was that many of these dividend-focused ETFs had heightened embedded credit risk based on their BBB and below exposure, which is normally not an issue during a healthy credit environment and normal corporate borrowing levels.

The S&P 500 has roughly a third of its portfolio in BBB and below-rated issues, but the index concentrates its exposures to market capitalization rather than dividends. We argued that “since dividend-focused ETFs are delivering ‘participation’ in dividend-paying risk, they are more susceptible to a shift in capital allocation policies that prioritize debtholders over equity shareholders.”

Figure 5 displays the same list of ETFs with updated figures through July 31, 2019.

Figure 5: Credit Risk Exposures Of Dividend-Focused ETFs & The S&P 500 (updated 7/31/2019)

Comparing Figures 4 and 5, the projected dividend yields have not changed that much between last December versus this July, despite the strong market advance that has seen the projected dividend yield on the S&P 500 drop from 2.03% to 1.89%.

Dividend-focused ETFs with higher credit risk tend to have higher projected yields relative to their peers, as would be expected. Some of the higher yield may be due to discounting of zero growth or cuts in dividend payouts as lower-rated companies pay down their debt.

Pendulum Swinging Back To Dividends

However, given this year’s drop in interest rates and rally in corporate credit, dividend-focused funds with projected 3.50-4.50% dividend yields are starting to look more attractive from a total return standpoint. That’s especially true if we’re about to enter an earnings slowdown over the next phase of this 10-year-plus business cycle.

In other words, whereas the income-focused risk/reward favored credit over dividends last December, the pendulum may now have shifted in favor of dividends over credit. Investors in dividend-focused strategies may not see much of a growth in payouts over the near term.

However, the fallen angel downgrade risk is not as prominent today as it was late last year, as highly leveraged investment-grade corporations firm up their balance sheets to head off a ratings downgrade into junk territory.

Should the U.S. economy remain resilient while the Fed cuts rates as projected by Fed Funds futures, dividend-focused investing will be on firmer footing today versus late last year.

A balanced income diet of risk and reward may now include a portion of dividends. On the other hand, fixed income investors seeking yield in corporate credit should start to question whether they are being properly compensated at current spread levels.

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