Hedging drives demand for Japan dividend futures

Moves by Japan structured product dealers to hedge out their long vega risk have created opportunities in the dividend swap markets for investors. But is this strategy really a one-way bet?

Finding yield is a complex task in current markets but Japanese investors have been facing this issue for longer than most as two decades of moribund domestic markets have driven them overseas – from the vanilla Aussie/Kiwi dollar carry trade to the more esoteric delights of the Brazilian real and the Turkish lira. But lately attention has shifted back to home, to the opportunities presented by dividends.

Japan dividend futures were listed on the Tokyo Stock Exchange (TSE) in 2010 – before then dividend swaps were traded over-the-counter primarily by hedge funds seeking to take advantage of short-term price movements in anticipated future company cash flows.

Index dividend futures track the dividends paid by all the companies in the index during one calendar year. On the ex-dividend date, when the dividend is about to be paid, the monetary value of each dividend is converted into a number of index points (Dips) and added to the index.

While the appeal of these products broadened to a wider set of investors after being listed by the TSE, it has grown at a slow pace for what is still a relatively complex product. But investors may find current conditions more attractive as dealers hedge out the risk across billions of dollars of retail structured products by offloading dividend futures, and hence their future long volatility (vega) positions are causing the dividend futures market to trade at a deep discount.

This is despite positive dividend forecasts, with futures listed on the TSE giving a 2013 dividend price as 202 Dips, according to Bloomberg/BNP Paribas. Go further forward and this trend is even more pronounced – in 2014 it is 191 Dips, in 2015 180 with the 2016 figures hitting 170 index points (see chart).

chart-japan-futures

According to Goldmans, this disparity is the result of hedging needs driving a decoupling between fundamentals and technicals which means the Nikkei dividend term structure implies minus 5.6% dividend growth per year from 2013 to 2018, whereas realised dividend growth has averaged 3% over the past five years. In contrast, both S&P and Euro Stoxx 50 dividend term structures are upward sloping.

Goldman Sachs believes this makes dividend futures an attractive investment proposition: “The Nikkei dividend future trading level is inexpensive from our bottom-up fundamental analysis,” says Naohide Une, head of equity derivatives trading at Goldman Sachs Japan in Tokyo. “The current opportunity is caused by an interesting supply and demand imbalance in this market.”

Dealers say the reason for this imbalance is the need for structured product providers to offload their significant risk positions in the dividend swaps market. Retail structured product providers such as Nomura, SMBC and Nikko Securities – and also Goldman Sachs Japan, however it says its positions are much smaller – are offloading dividends on a large scale because retail investors buy structured notes and hold on to them until redemption leaving dealers to hedge their long vega/dividend positions.

“Investors are selling Nikkei put options to brokers and because there are US$25 billion of these structured bonds in the market, the impact is like that of a big fish in a small pond – and consequently driving down derivatives pricing in the dividends market,” says Ueda.

This means dealers end up being long put options and in order to hedge the risk, they have to sell out the long vega risk and the long dividends risk in considerable size. “That’s why they are happy to sell dividend futures at an inexpensive level,” says Ueda.

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