Investors buy stocks or bonds issued by a corporate (the Issuer). For the period that they hold the stock or bond, they have an Asset and the Issuer has the Liability. Investor's can receive a return on their investment through a few different methods. The Investor's return on Asset will be impacted by the following:
Equity Dividend Distributions
Debt Interest Payments
Capital Gains
Share Buybacks
In a Treasury function (specifically in a Capital Management role in Corporate Treasury), it is important to understand these items in detail. Here is my attempt at explaining these concepts as I understand them.
Dividend Distributions
Investors who own stock (i.e. equity) own a share of the issuing company. They expect to be paid a part of the profits of the company in return for their investment. The proportion of the profits that is paid to the investors is commonly referred to as the 'Dividend Payout Ratio'. Also, not all Equity Investors are equal. As discussed in the 'Equities Asset Class' post, companies will issue ordinary common shares or preference shares. Dividend Distributions are first available to preference shares and then to ordinary shareholders.
Dividend Distribution process therefore has the following key steps:
Agree a Dividend Payout Ratio. This is an internal matter discussed between the Group Treasurer and the CFO, and finally approved by the CEO and the Board
Apply the ratio on profit after tax generated for the year to derive the quantum of capital that will be paid as total dividend amounts to all the equity investors
Divide the dividend amount by total outstanding shares to derive a Dividend per Share (DPS). This will be announced to the investors.
Pay the investors in line with the pecking order per shareholder's agreement
Key things to know about Dividends:
Most companies pay Dividends twice a year. They are referred to as interim and final dividends. Some companies pay Dividends quarterly. The frequency of dividend payments can be looked up in the investor relations website of the public company.
Dividend payments can provide shareholders a steady source of income. But, it is important to note that dividend distributions are at management's discretion. They are not guaranteed, and size of the dividends can vary from one payment to the next. Under stress scenarios, many firms cancel dividend payments to preserve cash for covering any liquidity risk or net working capital requirements.
Dividends are not a P&L item for Issuers and therefore, it will not show in the Issuer's Income Statement. Any current dividends paid will be deducted from the Issuer's Retained Earnings Reserve. Furthermore, any announced future dividend will also need to be deducted from Retained Earnings Reserve. In Banking (CRDIV regulation) - if a future dividend is not externally announced, a monthly accrual to meet an internally planned future foreseeable dividend should be deducted from the bank's monthly regulatory capital. This rule is to avoid any sudden increase in capital deductions when dividends are due, allowing the banks to accrue steadily every month towards a foreseeable dividend payment.
Dividends are deductions from the Issuer's Retained Earnings Reserve Capital, which forms part of the Shareholder's Equity on the Balance Sheet. On the Asset side, Dividend payments are deduction from Cash. Paying dividends will reduce the denominator in the calculation of Returns on Shareholder's Equity. It is important to note that Dividends are not Expenses, so they don't impact the Returns (i.e. the numerator).
Interest Payments
Investors who own Debt issued by a corporate will receive interest payments or coupon payments at a certain frequency and for a certain duration per the agreements in the loan documents, which are settled at the time of issuance. These documents should be publicly available on the issuer's investor relations website for all publicly traded debt. The interest payments on Debt can be either Fixed Rate or Floating Rate.
Key things to know about Interest Payments:
Issuers have to follow a day-count convention system to calculate the amount of accrued interest on debt instruments. This is a standardized way used in the financial services industry to calculate the number days between two dates. There are different representations of the day-count conventions within the standardized system. The debt agreement document will specify the convention to use.
Interest Payments on debt is a P&L item captured as Interest Expense in the Income Statement.
Unlike dividends, Interest Payments on debt are mandatory. Failure to make interest payments to lenders (i.e. Debt Investors) can trigger an event of default. A key ratio to track the ability of a firm to meet its interest obligations is the 'Interest Coverage Ratio' - this is ratio between the firm's EBITDA and the net interest expense. The ratio is often used in Credit Rating Agency's opinions as a way to check if the firm is generating sufficient cash (represented by EBITDA) to be able to meet its interest payments when they fall due.
Debt instruments can be issued in many different currencies. Interest Payments are generally due in the same currency as the notional of the debt. Therefore, interest payments on debt are subject to FX risk. Any swings in FX rates can impact the interest amounts due.
There are some Debt instruments that are Equity Accounted but have debt like features. For Example: Additional Tier 1 Contingent Convertible Bonds (AT1 CoCo). These instruments have four key differences compared to other debt accounted instruments.
These instruments receive a Tax Credit on their interest payments. Meaning, if the issuer pays 7% coupon on £1bn notional, the effective coupon rate is only 5.6% assuming a 20% tax credit. This helps lower the cost of capital. There are some countries where the tax credit rule does not apply (for example: Netherlands)
The capital value of these instruments does not fluctuate for FX Rates. The notional and the interest payments are all based on the FX Rates on the issue date. This feature is similar to equity instruments i.e. shares
Coupons or Interest Payments on these instruments are discretionary and not mandatory. Under stress, the issuer can choose to cancel interest payments on these instruments to preserve cash (similar to cancelling dividends on equity/shares)
AT1 CoCos are perpetual instruments i.e. no maturity date. However, they generally have a Call Date. When the issuer redeems the instrument on Call Date, the transaction may result in a gain (or loss) depending on the FX rate move between the Issue Date and the Call Date. This gain (or loss) is realized only on redemption of the instrument unlike the other debt accounted instruments which continuously fluctuate for FX rate movements.
Due to the above key differences, AT1 CoCos have higher coupon interest rates to compensate for the higher risk relative to subordinated debt instruments.
Capital Gains
When a corporate issues shares or bonds, the issuance happens in a primary market. Investors buy these assets in the primary market but not all investors may choose to hold the asset in their portfolio. Almost all primary market issuance are traded in the secondary market. If an Investor were to sell their Asset in the secondary market, any profit (or loss) they make from the trade is a Capital Gains (or Loss as the case maybe) for the investor. This Gain (or Loss) is not paid for by the Issuer.
From an investor's perspective:
Capital Gains are taxed differently based on when the sale of the asset happens
If the investor sold the asset within the first year of buying it, short-term capital gains tax will be applied, which reflects the tax rates on the investor's ordinary income for the year.
If the investor sold the asset after a few years of buying it, long-term capital gains tax will be applied. The tax rate can be as low as 0% if the investor sold the asset after at least 3 years of holding it in some countries.
Understanding the Capital Gains from an investor's perspective is important to fully understand the implications of a Share Buyback that a Corporate's Treasury function may recommend.
Share Buybacks A share buyback is when the corporate (issuer) uses its extra cash to buy its own shares from the secondary market. Investors who continue to own the same quantum of shares, now will own more percentage of the company as there are fewer shares in existence, i.e. investors will have a bigger slice of the same pie. This increases the trading value of the share in the market. Earnings per Share (EPS) metric will also show improvement as the denominator would have reduced due to share buy back. However, the improvement in EPS metric is not necessarily an indicator for value-add in this case.
Share buybacks generally take place when the company's management thinks the shares are undervalued. The buyback pushes the share price up, allowing investors to sell their shares at a higher price to make capital gains if they wish to.
The main difference between dividends and buybacks is that a dividend payment represents a definite return in the current time frame that will be taxed at the current rate, whereas a buyback represents an uncertain future return on which tax is deferred until the shares are sold by the investor.
Many US investors prefer share buybacks over dividend payments as they prefer capital gains over dividend income from a tax perspective. This is one of the main reasons why buybacks are very popular in the US. Among UK and EU investors, this preference does not exist. Buybacks only happen in Europe when the company genuinely has excess cash or if the share is really undervalued. There are many banking stocks in the UK that are very undervalued today from a price to book perspective.
If majority of the equity investors in a bank have held their stock for a long period (say more than 1 year), and if the share price was undervalued in the secondary market, Treasury Function in a Corporate can potentially recommend a Share Buyback strategy to both benefit the company and its long term investors. It can be a win:win strategy if executed at the right time and the right price.
Final Thoughts
Similar to stocks, bonds can also be bought back from the market. We will discuss this in a separate post on Liability Management Exercise.
Under CRDIV regulations on Banks, when certain covenants and thresholds are breached, the banks are not allowed to make discretionary payments (dividends and AT1 interests). These restrictions are referred to as 'Maximum Distributable Amounts (MDA)'. We will discuss MDAs in a separate post.
To summarize this post:
Dividend payment is discretionary and is not an Income Statement item. It is represented in the Balance Sheet as reduction in cash on the Asset side balanced by reduction on Retained Earnings Reserve in Shareholder's Equity on the Liability side
Coupons/Interests on Debt is mandatory and is an interest expense in the Income Statement.
Equity accounted instruments (like AT1 CoCos) have four key differences compared to Debt instruments - (i) discretionary coupons, (ii) issuer receives a tax credit on coupon payments (iii) interest and notional value do not fluctuate for FX changes and (iv) gain (or loss) due to FX move is realized on redemption
Capital Gains (or Losses) are realized when Investors sell their assets (stocks or bonds) in the secondary trading market. From an investor perspective, taxes on capital gains can be different to taxes on dividend income.
Share buybacks help investors through increased share value and increased share of the pie. Investors can benefit from buybacks when they sell the shares at a higher price, leading to capital gains. In some countries (such as US), investors tend to prefer buybacks over dividends.
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