10/1/20: Market Update by Jack Ablin, Chief Investment Officer at Cresset
Dividend payments to shareholders have become an increasingly important source of investment income in recent years as bond yields have plummeted. At its peak in 1982, the 10-year Treasury yield reached 14.3 per cent, more than nine percentage points higher than the S&P 500 dividend yield. By 2008 the relationship reversed, and the benchmark Treasury yield slipped below blue-chip dividend yields for the first time since the 1950s. Thanks to aggressive monetary policy, the benchmark Treasury yield is expected to remain consistently below that of equities indefinitely.
Fiscal policy has also influenced capital allocation over the years, particularly among corporate management. Thanks to the deductibility of interest payments and the double taxation of dividends, Washington prompted management to favor debt issuance over increasing equity capital. The Fed’s interest rate policies over the last few decades have supported those measures. As a consequence, corporate debt skyrocketed while equity issuance stagnated. In fact, share buybacks – the retirement of shares outstanding – have outpaced equity issuance very consistently over the last two decades (with the exception of three individual quarters), according to Federal Reserve data. Management’s preference for buybacks over dividends has been driven by other incentives beyond tax efficiency. Buybacks are ad hoc and can be announced and implemented at will, while dividends carry on ongoing commitment. Canceling a buyback program can be done quietly while dividend cuts and suspensions are much more visible and carry solvency connotations. The biggest factor weighing in buyback’s favor, however, is its ability to raise earnings per share (EPS) growth by reducing the denominator of the EPS quotient. Management can expand their company’s price-to-earnings ratio by boosting their EPS growth, a move that increases the value of their option holdings and burnishes their incentive compensation.
Corporate debt, meanwhile, has been on the rise since the 1990s, outpacing economic growth consistently for three decades. At 36 per cent of the economy, non-financial corporate debt is currently perched at an all-time high, fueled by a combination of low interest rates courtesy of the Fed and favorable tax treatment courtesy of Congress. Leverage has come at the cost of credit quality. In 1980, Standard & Poor’s rated 65 companies AAA worldwide, the rating agency’s highest rung on the credit ladder; more than half of all rated companies were rated A or above. Today, there are only five companies boasting a triple-A rating, with fewer than 14 per cent rated A or above, according to the Financial Times. Corporate bond credit quality is concentrated in the BBB range nowadays.
The COVID-19 economy introduced additional stress on dividends and buybacks, particularly as fewer companies were afforded financial flexibility. Even though Congress spent more than $2.5 trillion combating the lockdown and the Federal Reserve injected more than $3 trillion into the financial system, dividend and interest coverage ratios fell, forcing companies to cut or suspend dividends and eliminate share buybacks. All told, dividends globally fell by more than 20 per cent, to $382 billion, in Q2/20, according to the Financial Times. Buybacks, meanwhile, have been cut in half this year.
Government support comes with strings attached. The airlines, for example, received $26 billion as part of Congress’s financial aid package. Washington will undoubtedly impose restrictions on share buybacks and dividend payouts among air carriers, like what lawmakers required of banks after the financial crisis bailout.
Dividend policy has broad implications for income-oriented investors. Our bottom line is that investors need to focus on balance sheet quality, not yield, as a yardstick. High upfront dividends could come at the cost of future share price erosion. Dividend achievers – those companies with a long history of maintaining and raising their payouts – are better positioned to deliver consistent dividends to investors in this environment.
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