Source: pxhere.com. Labeled for reuse (Creative Commons CC0).
Note: an edited version of this article was published on ETF.com.
“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 over-leveraged 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 4Q2018, the income-focused risk/reward was shifting from dividend-paying strategies to corporate credit.
Although we did not initially foresee the Fed pull 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 headwind to tailwind, 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 and 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 nor the increased resiliency of the U.S. economy. In a 7/31/2019 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 (bold emphasis 3D).” 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.
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 they no longer have access to the fridge. However, BofA’s observations on corporate balance sheet improvements confirmed what we had wrote 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 Years 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 rather than being forced to take such measures after an economic recession has already taken place.
Credit Investors Rejoice (Dividend Investors, Not So Much)
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 – Credit Investors Benefit from the Balance Sheet Diet, While Dividend-Focused Strategies Lag the Broader Market Advance (Cumulative Log Excess Return YTD through July 2019)
Granted, it has not been a terrible year for dividend-paying strategies as they’ve still benefited from a strong U.S. market advance, but it’s clear that credit investors have enjoyed greater ‘risk’ compensation versus dividend recipients who 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)
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.
Revisiting Corporate Credit Risk in Dividend-Focused Exchange-Traded Funds (“ETFs”)
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 and 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 & 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, then 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 7/31/2019.
Figure 5 – Credit Risk Exposures of Dividend-Focused ETFs and the S&P 500 (Updated 7/31/2019)
Comparing Figure 4 and Figure 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. 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, especially if we’re about to enter a period of 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, but 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, then 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.
As of the time of this writing, 3D Asset Management held SCHD and SPY across the firm’s managed accounts. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
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