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  • Dividend Cuts and Interest Rates

    Posted by Carl from Chicago on February 19th, 2010 (All posts by )

    Recently I wrote about how Interactive Brokers was offering to lend money at 1.25% in order to purchase stocks yielding 5% or more in dividends. I was struck by the low rate that they were able to offer as interest and the fact that there was a large universe of large companies offering such high dividend payouts (and not just companies that had a stock price decline with a dividend cut yet to follow so it was unusually high relative to the stock value).

    To give Interactive Brokers some credit, the ad was kind of “tongue in cheek” in that it was made to look like it was written on a napkin like the classic business plan but there were enough elements there to get me thinking about what an odd state of affairs this represented.

    Just recently this model started coming under siege. The Fed recently began tightening interest rates, increasing the discount rate to 0.75% from 0.5%. While the Fed has been denying that this is part of a long term policy shift, the markets have started to feel otherwise, as markets went down and yields increased on government debt. This won’t directly impact the 1.25% that they are able to borrow for on the “napkin” today, but it seems to be trending that way, even if this is just a first step.

    On the other side, 2 large European firms just cut their high dividends. Daimler Benz (DAI), manufacturer of Mercedes autos, suffered a loss and canceled their dividend, leading to a drop of 4.6% in their stock price in one day. Societe Generale, a large French investment bank, cut their dividend from $1.2 Euros to $0.25 Euros (a drop of 79%) and their stock also fell 7.2% in a day.

    The question is – how can companies pay out such high dividends in a sustainable manner when there isn’t much growth in the world economy and many of them are in mature industries? While 2 stocks don’t constitute a balanced statistical survey, they show that dividends are a function of profits and long-term profit view and to talk about them in an “historical” view is backwards.

    The other side of this is that investing for yield in such a volatile area as stock prices shows that not only did the long term value of the income stream from dividends drop significantly (in the case of Daimler it dropped to zero, and for Societe it dropped by 79%) but then you can also see the impact on the underlying value of the shares, which dropped 4.6% and 7.9% in ONE DAY.

    Cross posted at LITGM and Trust Funds for Kids

     

    3 Responses to “Dividend Cuts and Interest Rates”

    1. Jonathan Says:

      The carry trade is a classic short-gamma deal. Easy, steady returns comes with the risk of sudden adverse stock or currency price movement that wipes out your accumulated profits and more. You really have to consider the risk as part of the deal, and then it doesn’t look as good.

      As to why companies keep paying out dividends, maybe they can’t. Maybe they pay dividends because in the current economic environment mgmt can’t find better uses for the money.

    2. david foster Says:

      In a slow-growth environment, of course, companies can afford to pay higher dividends because (all other things being equal) they don’t need to reinvest as much money to support growth.

      There seems to be considerable evidence that when unneeded cash is retained instead of being paid out, sooner or later somebody does something dumb with it…

    3. Simon Kenton Says:

      Many decades past, one of the first stocks I bought was selling at 4, making 1, and paying out 10 cents. Mature company, mature industry. I wrote them suggesting they raise the dividend, and of course they said nothing and did nothing. Not much later some corporate looter came along and offered 8. Management sent us a letter, by turns indignant and piteous, urging us to stick with the team that had gotten us where we were, etc. I wrote them back to say I was selling at 8 and I hoped the new management would can them one and all. So it happened. Forever afterward I have been irritated by government or politicians blocking or decrying takeovers. Capitalism – the original and still the only effective recycling program.