How Stock Dividend Works

To determine whether you should get a dividend, you need to look at two important dates. They are the “record date” or “date of record” and the “ex-dividend date” or “ex-date.”

When a company declares a dividend, it sets a record date when you must be on the company’s books as a shareholder to receive the dividend. Companies also use this date to determine who is sent proxy statements, financial reports, and other information.

Once the company sets the record date, the ex-dividend date is set based on stock exchange rules. The ex-dividend date for stocks is usually set one business day before the record date. If you purchase a stock on its ex-dividend date or after, you will not receive the next dividend payment. Instead, the seller gets the dividend. If you purchase before the ex-dividend date, you get the dividend.

Here is an example:

Declaration Date: Friday, 9/8/2017
Ex-Dividend Date: Friday, 9/15/2017
Record Date: Monday, 9/18/2017
Payable Date: Tuesday, 10/3/2017

On September 8, 2017, Company XYZ declares a dividend payable on October 3, 2017 to its shareholders. XYZ also announces that shareholders of record on the company’s books on or before September 18, 2017 are entitled to the dividend. The stock would then go ex-dividend one business day before the record date.

In this example, the record date falls on a Monday. Excluding weekends and holidays, the ex-dividend is set one business day before the record date or the opening of the market—in this case on the preceding Friday. This means anyone who bought the stock on Friday or after would not get the dividend. At the same time, those who purchase before the ex-dividend date on Friday will receive the dividend.

With a significant dividend, the price of a stock may fall by that amount on the ex-dividend date.

If the dividend is 25% or more of the stock value, special rules apply to the determination of the ex-dividend date. In these cases, the ex-dividend date will be deferred until one business day after the dividend is paid. In the above example, the ex-dividend date for a stock that’s paying a dividend equal to 25% or more of its value, is October 4, 2017.

Sometimes a company pays a dividend in the form of stock rather than cash. The stock dividend may be additional shares in the company or in a subsidiary being spun off. The procedures for stock dividends may be different from cash dividends. The ex-dividend date is set the first business day after the stock dividend is paid (and is also after the record date).

If you sell your stock before the ex-dividend date, you also are selling away your right to the stock dividend. Your sale includes an obligation to deliver any shares acquired as a result of the dividend to the buyer of your shares, since the seller will receive an I.O.U. or “due bill” from his or her broker for the additional shares. Thus, it is important to remember that the day you can sell your shares without being obligated to deliver the additional shares is not the first business day after the record date, but usually is the first business day after the stock dividend is paid.

References

https://www.investor.gov/additional-resources/general-resources/glossary/ex-dividend-dates-when-are-you-entitled-stock-cash

Ex-Dividend Date

Once the company sets the record date, the ex-dividend date is set based on stock exchange rules. The ex-dividend date for stocks is usually set one business day before the record date. If you purchase a stock on its ex-dividend date or after, you will not receive the next dividend payment. Instead, the seller gets the dividend. If you purchase before the ex-dividend date, you get the dividend.

Convertible Bond

A conertible bond is a bond with an embedded conversion option that gives the bondholder the right to convert their bonds into the issuer’s common stock during a pre-determined period at a pre-determined price.

A convertible bond is a hybrid security. In its traditional form, it presents the characteristics of an option-free bond and an embedded conversion option. The conversion option is a call option on the issuer’s common stock, which gives bondholders the right to convert their debt into equity during a pre-determined period (known as the conversion period) at a pre-determined price (known as the conversion price).

Convertible bonds have been issued and traded since the 1880s. They offer benefits to both the issuer and the investors. Investors usually accept a lower coupon for convertible bonds than for otherwise identical non-convertible bonds because they can participate in the potential upside through the conversion mechanism—that is, if the share price of the issuer’s common stock (underlying share price) exceeds the conversion price, the bondholders can convert their bonds into shares at a cost lower than market value. The issuer benefits from paying a lower coupon. In case of conversion, an added benefit for the issuer is that it no longer has to repay the debt that was converted into equity.

However, what might appear as a win–win situation for both the issuer and the investors is not a “free lunch” because the issuer’s existing shareholders face dilution in case of conversion. In addition, if the underlying share price remains below the conversion price and the bond is not converted, the issuer must repay the debt or refinance it, potentially at a higher cost. If conversion is not achieved, the bondholders will have lost interest income relative to an otherwise identical non-convertible bond that would have been issued with a higher coupon and would have thus offered investors an additional spread.

Capped Floater

A capped floater is a floating-rate bond with a cap provision that prevents the coupon rate from increasing above a specified maximum rate. As a consequence, the cap provision protects the issuer against rising interest rates and is thus an issuer option.

Because the investor is long the bond but short the embedded option, the value of the cap decreases the value of the capped floater relative to the value of the straight bond:

Value of Capped Floater = Value of Straight Bond – Value of Embedded Cap

Interest Rate Risk

The interest rate risk is the risk that an investment’s value will change due to changes related to the interest rate. These changes include variations in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship.

Measure

Some key measures of interest rate risk include duration and convexity.

Duration

The duration of a bond measures the sensitivity of the bond’s full price (including accrued interest) to changes in the bond’s yield to maturity (in the case of yield duration measures) or to changes in benchmark interest rates (in the case of yield-curve or curve duration measures). Duration is among the most important characteristics of a fixed income security. It is often used as a measure of risk in bond investing.

Duration comes in many forms. Yield duration measures, such as modified duration, can be used only for option-free bonds because these measures assume that a bond’s expected cash flows do not change when the yield changes. This assumption is in general false for bonds with embedded options because the values of embedded options are typically contingent on interest rates. Thus, for bonds with embedded options, the only appropriate duration measure is the curve duration measure known as effective (or option-adjusted) duration. Because effective duration works for straight bonds as well as for bonds with embedded options, practitioners tend to use it regardless of the type of bond being analyzed.

Brief History

In 1938, economist Frederick Macaulay suggested duration as a way of determining the price volatility of bonds. ‘Macaulay duration’ is now the most common duration measure.

Until the 1970s, few people paid attention to duration due to the relative stability of interest rates. When interest rates began to rise dramatically, investors became very interested in a tool that would help them assess the price volatility of their fixed income investments. During this period, the concept of ‘modified duration’ was developed, which offered a more precise calculation of the change in bond prices given varying coupon payment schedules.

In the mid-1980s, as interest rates began to drop, several investment banks developed the concept of ‘option-adjusted duration’ (or ‘effective duration’), which allowed for the calculation of price movements given the existence of call features.

Different Duration Measures

While duration comes in many forms, the ones most commonly used by public fund investors include the following:

Macaulay Duration

Developed in 1938 by Frederic Macaulay, this form of duration measures the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received in the future. Thus, it is the only type of duration quoted in “years.” Interest rates are assumed to be continuously compounded.

Modified Duration

This measure expands or modifies Macaulay duration to measure the responsiveness of a bond’s price to interest rate changes. It is defined as the percentage change in price for a 100 basis point change in interest rates. The formula assumes that the cash flows of the bond do not change as interest rates change (which is not the case for most callable bonds).

Effective Duration

Effective duration (sometimes called option-adjusted duration) further refines the modified duration calculation and is particularly useful when a portfolio contains callable securities. Effective duration requires the use of a complex model for pricing bonds that adjusts the price of the bond to reflect changes in the value of the bond’s “embedded options” (e.g., call options or a sinking fund schedule) based on the probability that the option will be exercised. Effective duration incorporates a bond’s yield, coupon, final maturity and call features into one number that indicates how price-sensitive a bond or portfolio is to changes in interest rates.

Extendible Bond

Another type of embedded option that resembles a put option is an extension option: At maturity, the holder of an extendible bond has the right to keep the bond for a number of years after maturity, possibly with a different coupon. In this case, the terms of the bond’s indenture or offering circular are modified, but the bond remains outstanding. Examples of extendible bonds can be found among Canadian issuers such as Royal Bank of Canada, which, as of July 2013, has a 1.125% semi-annual coupon bond outstanding that matures on 22 July 2016 but is extendible to 21 July 2017.

Putable Bond

A putable bond is a bond that includes an embedded put option. The put option is an investor option—that is, the right to exercise the option is at the discretion of the bondholder. The put provision allows the bondholders to put back the bonds to the issuer prior to maturity, usually at par. This usually happens when interest rates have risen and higher-yielding bonds are available.

Similar to callable bonds, most putable bonds include lockout periods. They can be European or, rarely, Bermudan style, but there are no American-style putable bonds.

Reference

2018 CFA Program Level II Volume 5 Fixed Income and Derivatives.

Callable Bond

A callable bond is a bond that includes an embedded call option. The call option is an issuer option—that is, the right to exercise the option is at the discretion of the bond’s issuer. The call provision allows the issuer to redeem the bond issue prior to maturity. A callable bond is also called a redeemable bond.

Early redemption usually happens when the issuer has the opportunity to replace a high-coupon bond with another bond that has more favorable terms, typically when interest rates have fallen or when the issuer’s credit quality has improved.

Until the 1990s, most long-term corporate bonds in the United States were callable after either five or 10 years. The initial call price (exercise price) was typically at a premium above par, the premium depended on the coupon, and the call price gradually declined to par a few years prior to maturity. Today, most investment-grade corporate bonds are essentially non-refundable. They may have a “make-whole call,” so named because the call price is such that the bondholders are more than “made whole” (compensated) in exchange for surrendering their bonds. The call price is calculated at a narrow spread to a benchmark security, usually an on-the-run sovereign bond such as Treasuries in the United States or gilts in the United Kingdom. Thus, economical refunding is virtually out of question, and investors need have no fear of receiving less than their bonds are worth.

Most callable bonds include a lockout period during which the issuer cannot call the bond. For example, a 10-year callable bond may have a lockout period of three years, meaning that the first potential call date is three years after the bond’s issue date. Lockout periods may be as short as one month or extend to several years. For example, high-yield corporate bonds are often callable a few years after issuance. Holders of such bonds are usually less concerned about early redemption than about possible default. Of course, this perspective can change over the life of the bond—for example, if the issuer’s credit quality improves.

Callable bonds include different types of call features. The issuer of a European-style callable bond can only exercise the call option on a single date at the end of the lockout period. An American-style callable bond is continuously callable from the end of the lockout period until the maturity date. A Bermudan-style call option can be exercised only on a predetermined schedule of dates after the end of the lockout period. These dates are specified in the bond’s indenture or offering circular.

With a few exceptions, bonds issued by government-sponsored enterprises in the United States (e.g., Fannie Mae, Freddie Mac, Federal Home Loan Banks, and Federal Farm Credit Banks) are callable. These bonds tend to have relatively short maturities (5–10 years) and very short lockout periods (three months to one year). The call price is almost always at 100% of par, and the call option is often Bermudan style.

Tax-exempt municipal bonds (often called “munis”), a type of non-sovereign (local) government bond issued in the United States, are almost always callable at 100% of par any time after the end of the 10th year. They may also be eligible for advance refunding—a highly specialized topic that is not discussed here.

Although the bonds of US government-sponsored enterprises and municipal issuers account for most of the callable bonds issued and traded globally, bonds that include call provisions are also found in other countries in Asia Pacific, Europe, Canada, and Central and South America. The vast majority of callable bonds are denominated in US dollars or euros because of investors’ demand for securities issued in these currencies. Australia, the United Kingdom, Japan, and Norway are examples of countries where there is a market for callable bonds denominated in local currency.

References

2018 CFA Program Level II Volume 5 Fixed Income and Derivatives.