Thespread Between the Bond Yield and the Dividend Yieldand the Dividend Premium

TheSpread between the Bond Yield and the Dividend Yieldand the Dividend Premium

Abstract

Empirical tests of the catering theory of dividends find that payout policy is influenced by the dividend premium, the relative market valuations of dividend paying versus non-paying firms. This paper offers the yield spread hypothesis of the dividend premium:investors tend to placelower valuations on dividend paying stocks when their yield is relatively low compared to risk-free bonds. After controlling for other variables that may affect the dividend premium, I find the spread between the one-year US Treasury note and the S&P 500 dividend yield issignificantly and inversely associated with the dividend premium. The results are consistent with investors that have regular cash distribution preferences comparing yields on competing financial instruments.

Key Words: Dividend premium, Payout policy, Bond yield, Dividend yield

I. Introduction

Miller and Modigliani’s (1961) theoretical paper on dividends led them to their famous proposition thatdividend policydoes not affect firm value. They arrived at their conclusion by assuming perfect capital markets and a fixed corporate investment plan. These restrictions are not representative of the real environment in which investors and firms operate. Relaxing them to gain insight into the dividend policy choices of managershas been the focus of much subsequent research.

One recent theory of dividend policy is thecatering model proposed by Baker and Wurgler (2004), from now on “BW”.BW relaxes Miller and Modigliani’s (1961) assumption that stocks are always priced efficiently. They theorize that investor demand for dividend-paying stocks varies through time and can result in themispricing offirms that pay dividends versus those that do not. The valuation discrepancies can persist because of structural inefficiencies in the financial markets.[1]BW call this valuation differential the “dividend premium”, which is calculated as the natural log of the ratio of average market-to-book values of payers and non-payers.[2] BW hypothesize that managers know when their firms are mispriced along this dimensionand make dividend policy decisions accordingly to maximize shareholder value. For example, BW predict that when investors place a relatively high valuation on firms that pay dividends, managers will be more likely to initiate a dividend.

The empirical evidence supports the catering theory. BW show that changes in the dividend premium explain 60% of the annual variation in dividend initiations over a forty year sample period.Li and Lie (2006) apply the catering theory to a sample of dividend increases and decreases (as opposed to BW’s initiation and omission sample) and show that variation in the dividend premium is a significant determinant of these more frequent, ongoing payout policy decisions.Bulan et al. (2007) find that the dividend premium is a strong predictor of dividend initiations and Ferris et al. (2006) provide international evidence in favor of the catering theory of dividend policy.

Despite these empirical findings, Lee (2011) notesthat there has been little written on thefactorsthat influence the dividend premium.[3]This paper seeks to fill this gap in the literature and proposes that the dividend premium is associatedwith the spread between the yield onthe one-year Treasury note and the S&P 500 dividend yield.I assume that there are classes of investors that prefer equity securities that distribute cash at regular intervals.[4]Firms that pay dividends tend do so at regular intervals and rarely reduce them.[5] These two features make dividends a viable substitute to interest payments from debt securities.There have been numerous stories in the financial press discussing this tradeoff between low interest rates and dividend yields during the low interest rate environment of 2008-2014.[6]

While the relative risks of bonds and stocks are generally different, the fixed-income market and dividendpaying stocks form part of an investment opportunity set for investors seekingsecurities with cash distributions.I hypothesize that when bond securities offer relatively low yields, investors seek current income from alternative investments, such as dividend-paying stocks.These dividend-paying stocks may receive higher valuations from this increased demand which would be reflected in a higher dividend premium. Alternatively, when the yield on bond securities is high relative to the dividend yield, I predict the dividend premium will be relatively low as investors have an attractive alternative to satisfy their demand for periodic cash proceeds.

The evidence is this paper broadly supports the yield spread hypothesis: after controlling for other variables that may affect the dividend premium, such as investor sentiment, age variation in the population, agency costs, tax differentials, business cycle fluctuations, and profitability, the spread variable is significantly and inversely associated with the dividend premium. I also show that the spread between a portfolio of Moody’s Baa-rated corporate bonds and the dividend yield, which is more likely to reflect investor sentiment and the risk premium, is generally not associated with the dividend premium in the main multivariate framework. These results are consistent with investorsplacing a premium valuation on dividend paying stocks when their yield is comparatively high compared to default risk-free bond yields and vice versa.

This paper contributes to the existing literature on dividend policy in severalways. First, I offer a new factor that helps explain the variation in the dividend premium, the force behind the catering theory of dividend policy.This bond yield-dividend yield spread variable is robust to a number of specifications.Despite all of the attention on dividends over the past fifty years, I am not aware of any study that has directly postulated that the competing yields on fixed income products can have an impact on a firm’s dividend policy decisions.[7]The omission of fixed-income yield variables in the extant dividend premium models is somewhat surprising because the tradeoff between debt and equity yields is a reasonable conjecture on what affects the demand for dividend-paying stocks.

Second, the theoretical underpinnings of the yield spread hypothesis are more comprehensive than the demographic theory of the dividend premium put forth by Lee (2011).He makes a convincing argument that changes in the age structure of the population drives movements in the dividend premium. However, an age-based explanation cannot account for why investors would prefer dividend-paying equities when risk-free securities offer high yields, nor does it account for the risk-averse preferences of investors that do not fit a particular age profile. My empirical analysis shows that the significance of the age structure variable is subsumed by the spread variable.

Third, my empirical testsare somewhat more powerful than previous studies on the dividend premium. For example, annual data on the age structure of the population are estimates based on census data which is officially measured only once every decade. On the other hand, spreads between bond and dividend yields can be measured more precisely and monthly, providing a sample size that is ten-times as large as prior studies on the dividend premium.

II. Literature Review

Why dividends?

Why might investors demand dividends in the first place?[8]Miller and Modigliani (1961) argue that dividend policy is irrelevant to firm valuation because investors can create homemade dividends by selling shares to generate income.In a world with taxes, such a strategy would be efficient if the tax rate on capital gains is less than the tax rate on dividends, as is often the case. However, Black (1976) notes the preference for a cash dividend by some investors is undeniable. He briefly reviews many mainstream reasons why dividends may be preferred (or not preferred) and debunks them all leaving us with his famous “dividend puzzle”. Potential explanationsfor why dividends exist largely relate to market inefficiencies, tax policy, information asymmetry, and agency costs.[9]

Behavioral theorists also offer alternative explanations of the preference of dividend payments even in the absence of market frictions. For example, Shefrin and Statman (1984) use Thaler and Shefrin’s (1981) self-control framework and argue that investors with difficulties controlling their will power may prefer dividends to selling shares themselves in order to avoid the temptation of reducing the principal invested too quickly. Shefrin and Statman (1984) also argue that investors who are averse to regret will prefer to finance current consumption out of dividends lest they miss out on the potential future capital appreciation of shares they sold. Regardless of the source of investor demand for dividends, I assume that there are at least some investors that prefer stocks that pay dividends. This assumption is broadly consistent with the empirical evidence on dividends.[10]

The Dividend Premium

BW attributes the link between the dividend premium and dividend decisions to managers rationally catering to their shareholders by exploiting market mispricing. They arrived at this conclusion in several steps. First, they systematically eliminate explanations related to time-variation in firm characteristics, such as growth opportunities, and agency costs because these reasons were inconsistent with their full set of results.BW then asks “Who are managers catering to?” BW show that managers do not appear to be catering to clienteles based on tax concerns, transactions costs, and institutional investment constraints. This corresponds with survey evidence fromBrav et al. (2005) that suggests that managers do not consider the demands of clienteles of any sort.On the other hand, BW provides evidence that managers cater to investor sentiment: the dividend premium is positively correlated with the closed-end fund discount.[11] A large closed-end fund discount is associated with poor investor sentiment. When the discount is large, investors may drive up the relative valuation of dividend payers versus non-payers if they perceive the former as safer investments. While investor sentiment appears to play a pivotal role, BW admit that unresolved issues with what the closed-end fund discount truly measures detracts from its theoretical link with the dividend premium.

Other studies that have attempted to identify variables that affect the dividend premium have yielded mixed results. Liu and Shan (2007) tied changes in the dividend premium to proxies for agency costs and signaling motives, but Lee (2011) points out their results were not robust when a simple time trend was added to the model. In the most promising recent research, Lee (2011) finds that the dividend premium is positively correlated with demographic variation as measured by annual changes in the proportion of persons aged above 65 to those aged under 45.[12] His result is consistent with other research pertaining to dividend policy and demographics.For example, Becker et al. (2011) show that firms headquartered in areas in which seniors make up a large percentage of the population are more likely to initiate a dividend. Additionally, Graham and Kumar (2006) investigated retail investor stock trading behavior and found that older investors tend to buy stocks after dividend announcements and just before the ex-dividend date.

III. Hypothesis Development

Motivation

The demographic theory of the dividend premium put forth by Lee (2011) can be summarized as follows. Older investors tend to concentrate their portfolios in income generating investments when they turn 65 years old. The lack of labor income in this demographic could be an impetus that drives these investors to equity securities that offer income. Time variation in the older-to-younger ratio can impact the relative valuation difference between dividend payers and non-payers.[13] Specifically, as the ratio of older-to-younger persons in the economy increases compared to the prior year, dividend payers receive a premium valuation compared to non-payers, and vice-versa.

While the demographic explanation is very intuitive, I argue that it does not go farenough in several respects. First, there is no consideration of the full investment opportunity set facing investors. For example, if yields on debt securities were relatively high, there is little reason to suspect that yield-seeking, older investors would shift their portfolios to dividend-paying stocksen masse just because they are older.Additionally, the risk of receiving the interest payments and principal from bonds is lower than that of receiving dividends. It would not be surprising to find that the demographic variable is picking up the collective impact ofcompeting yields in the bond and equity markets. Second, there is little consideration paid to the risk-return preferences of the entire population of investors in the existing demographic theory. For example, younger investors that are relatively risk-averse may have a large percentage of their portfolio concentrated in income generating investments. Lease et al. (1976) find that approximately one-third of the portfolios of highly educated young professionals are concentrated in income securities. In other words, older investors are not the only clientele that invest in securities that distribute cash. Finally, changes in the old-to-young ratio assume that portfolios are not adjusted until an age reference point is hit. It is certainly possible that investors begin to adjust their portfolios before their actual age reaches a certain number in anticipation of cash needs. The way Lee (2011) calculates the old-young ratio would not capture this dynamic.

Main Hypothesis

The yield spread conjecture put forth in this paper incorporates the investment opportunity set facing investors as well as the full set of market participants available to purchase securities.The level of interest rates in the economy affects every investor to a certain degree as yields on outstanding and new securities compete with other types of securities for loanable funds.This is why the yield spread hypothesis of the dividend premium is more comprehensive than the demographic theory. Dividendsoffer an easy way for companies to cater to investors seeking yield in times of low interest rates, especially if the firm had been on the fence about initiating a dividend.

I assume that there are classes of investors that prefer dividend paying stocks, often called dividend clienteles, because they offer regular cash payments.[14] I conjecture that these investors also consider the yields available on other types of cash distributing securities when they make their portfolio choices. A relatively low spread between fixed-income yields and the S&P 500 dividend yield may result in higher valuationon dividend paying stocks (i.e., a higher dividend premium)via a shift outward in the demand curve.[15] On the other hand, when the bond rate is comparatively high, dividend-paying stocks lose their relative appeal since investors can obtain acceptable streams of cash from interest-bearing securities.This leads to the following hypothesis:

H1: The dividend premium is inversely related to the spread between the one-year Treasury note yields and the S&P 500 dividend yield. The higher the one-year Treasury yield compared to the dividend yield, the lower the dividend premium. The lower the one-year Treasury yield relative to the dividend yield, the higher the dividend premium.

I choose the one-year Treasury note yield in the dividend spread calculation to limit the confounding factors that could impact the spread. For example, using a corporate bond yield in the calculation of the spread above the dividend yield may reflect changes in investor sentiment or other factors as opposed to the cash distribution comparisons I am trying to model.

IV. Method and Sample

To test the yield spread hypothesis of the dividend premium I run OLS regressions using annual times series data from 1962 to 2004.[16]I include the same or very similar control variables found in other models of the dividend premium to test the yield spread hypothesis in a multivariate framework. The main model is (time subscripts suppressed):

DP = α + β1YIELD_SPREAD + β2ΔDEMOGRAPHIC + β3CEFD + β4GDP_GROWTH + β5TAX_RATIO + β6PROFIT_PREM + β7CASH_PREM + β8TIME + ε (1)

The variables,the data sources, and the expected signs on the coefficients (when particularly relevant) are below.

A. Dependent and Main Independent Variable

DIV_PREM =the dependent variable in all models and is defined as the difference between the natural logs of the value-weighted market-to-book ratios of dividend payers versus nonpayers. This variable was created by BW and can be obtained fromJeffrey Wurgler’s website.[17]

RF_DIV_SPRD= the main independent variable of focus and is defined as the difference between the one-year US Treasury note yield and the dividend yield of the S&P 500 index.It is a proxy for the trade- off investors face between the risk-free yield and the dividend yield. The data on the Treasury note is obtained from the Federal Reserve Economic Data (FRED) website and the S&P 500 dividend yield is cross checked from various publicly available sources. A negative slope coefficient is anticipated: as the spread between the one-year Treasury note yield and the S&P 500 dividend yield increases, the dividend premium tends to decrease.