There are a lot of products in the Wall Street jungle with which many investors are unfamiliar. One of those products – dividend swaps – can potentially offer dividend investors a unique way to lock in their dividend payments.
However, as with so many Wall Street products, dividend swaps are complex and not for novice investors. This article details the basics of dividend swaps and offers insight on how the product can be used by sophisticated investors.
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What Are Dividend Swaps?
Created in the late 1990s, dividend swaps are an over-the-counter product that allows investors access to pure-play dividend exposure. The creation of dividend swaps simplified the process of investing directly in dividends.
With this product class, investors can get direct exposure to dividend payouts by a firm. And because the product is a swap, no cash is exchanged upfront. This results in either big profits or big losses for investors, in many cases, compared to the capital they would have had to post for the trade. In other words, dividend swaps can be risky.
A swap is a trade between two parties usually involving “swapping” one set of payments for another. For example, a common swap involves trading a set of fixed payments based on a fixed interest rate in exchange for a set of payments that vary with the level of the Fed Funds rate or LIBOR. This is called a fixed-for-floating swap.
In a dividend swap, the purchaser of the swap agrees to pay a fixed dividend payment amount (fixed leg) in exchange for the sum of all qualifying dividends during the period of the swap (floating leg). In other words, it is a bit like buying a stock – you pay the brokerage firm/bank a fixed amount in exchange for getting payments equal to dividends paid out by a firm over time.
Payments for both the fixed and floating leg are made at the end of the swap contract’s term, so no money changes hands up front.
For example, an individual might agree to buy a swap on the S&P 500 and pay out a fixed $50K. In exchange, the individual is entitled to receive all of the ordinary dividends paid out by S&P 500 firms for a certain number of shares of stock, perhaps 1,000 shares of every S&P firm. If S&P firms begin raising their dividends and paying out more, then the purchaser of the swap would get more money. If they cut dividends, and payout less, then the purchaser of the swap gets less money.
This type of over-the-counter (OTC) product is only appropriate for sophisticated investors. Frankly in most cases, the fees that the brokerage firm charges for setting up the swap are substantial enough that it only makes sense to engage in a swap trade if you are investing a million dollars or more.
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Dividend Swaps for Hedging
Dividend swaps can be used for a variety of trading strategies if investors expect that companies are going to begin paying out more in dividends soon (for example in the months following a recession after dividends have been cut drastically). But dividends swaps can also be used for hedging purposes.
In particular, a dividend swap can be used to lock-in a guaranteed level of dividend payments for an investor over time. An investor who holds the S&P 500 and receives those dividend payments is exposed to the risk of dividend cuts in the future. By selling a dividend swap to a brokerage firm, the investor receives a fixed guaranteed dividend payment in exchange for paying the bank the dividends from the S&P 500. If dividends from the S&P are cut, then this is a good deal for the investor. If dividends rise, then the investor has lost out on potential income.
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Types of Dividend Swaps
As an OTC product, dividend swaps are highly customizable by the client dealing with the bank. Typically, though, there are three major types of dividend swaps: single-stock swaps, basket-of-stocks swaps, and index-based swaps.
As the name implies, single stock-based swaps are swaps where the underlying dividend trade is based on a single company. This type of swap might be appealing for investors with a very large position in a single company where the investor wants to secure their dividend payments or where the investor expects a series of rising dividend payments in the future.
For example, stock analysts might project that a utility company will be able to raise dividends next year, but those dividend increases have not yet been announced. In this case, if the investor agrees with analysts, they might want to sell a dividend swap to a bank as a speculative trade. Doing so entails no cash exchange upfront, so the investor could end up with either a big profit or a big loss.
Basket-of-stocks swaps operate the same way as a single-stock swap, but the basket-of-stock swaps are based on some predefined set of stocks that the investor and the bank have agreed upon. This helps to potentially diversify risk in the swap for the investor.
Index swaps are the most common. They are often based on a commonly used index such as the DJ Euro STOXX 50. Investors get exposure to dividends paid by the preset index on either the floating or fixed side.
The Bottom Line
Overall, dividend swaps is a product that is only appropriate for a small subset of investors. However, for the sophisticated investor looking to hedge their exposure to volatility in dividend payments, or to speculate on dividend payments in some fashion, the product can be a great tool. Dividend swaps can only be traded OTC via major banks and brokerages such as Barclays, so this is not a product available to many investors.
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