One second order impact of Covid-19 has been a reduction in stock buybacks. It is possible that companies will buy back less stock for the foreseeable future. Obviously there will be a temporary reduction in share buybacks, at least until the virus is under control. There is also the reasonable possibility that the reduction in buybacks is long term.  This has interesting implications for capital markets in general, and earnings derivatives in particular.

Why would buyback reductions be longer lasting this time around? Criticism of share buybacks is now a near mainstream position in both major US political parties. Although political discussion on the topic has been far from rational, some of the claims are directionally accurate and some of the concern is justified. If I recall correctly, most of the populist anger was directed toward executive bonuses during the 2008-2009 crisis, and there was less concern about stock buybacks outside of the banking sector. This time around there has been uproar over the amount of capital returned to investors in all sectors. Its even possible there will be permanent regulatory changes that make share buybacks as we know them impossible or less beneficial in the near future. Its also worthwhile remembering that share buybacks as we know them weren’t even allowed until recently(prior to the 1980s they were considered market manipulation so companies mainly paid dividends).

Ironically, dividends are less of a political hot button. In the US at least, dividends receive less favorable tax treatment, so they are less popular. That could change in the coming years.

Fewer stock buybacks+less consistent dividends=lower multiples

Its possible companies will just operate with more conservative balance, even after the economy recovers from the Covid-19 shutdowns, only returning capital to investors when pressured to do so. If this happens the inability/unwillingness of companies to return capital to investors could lead to lower multiples, and make it more difficult to benefit from earnings growth by buying stock. In this case long dated positions in earnings derivatives might be more attractive than underlying equity for some investors.

Investors are have become accustomed to companies following consistent buyback and/or dividend policies. They will have to change their approach in the new reality

Implications of dividend volatility

If dividends become more volatile that has interesting implications for the valuation of a lot of equity derivative products. Specifically,  these changes will impact the cost of carry faced by market makers.  The cost of carry is what market makers charge when they sell a call option (the spread between a call and a put at the same strike and same expiration date).

The official definition:

Mathematically speaking, Cost of carry (COC) is the annualized interest percentage cost for a futures contract versus a similar position in cash market and carried to maturity of the futures contract, less any dividend expected till the expiry of the contract.

Any portfolio involving long term call options faces cost of carry risk exposure There are plenty of products available for interest rate risk management.  However there are fewer products for managing dividend risk.  The dividend futures market provides only partial help.

Earnings derivatives can be useful complement to strategies with long term equity call options or put/call arbitrage components. Earnings derivatives would complement and enhance the existing dividend derivatives markets.