Reaching for dividends

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Reaching for dividends Hao Jiang a,∗, Zheng Sun b a b

Eli Broad College of Business, Michigan State University, United States Paul Merage School of Business, University of California, Irvine, United States

a r t i c l e

i n f o

Article history: Received 7 May 2019 Revised 8 August 2019 Accepted 12 August 2019 Available online xxx JEL classification: E40 E50 G10 G20

a b s t r a c t Interest rates dived into uncharted territories for an extended period after the financial crisis. What is the impact on investor behavior and asset prices? We find that when interest rates fall, flows into income-oriented equity funds increase, with higher dividend-yielding funds attracting more inflows after controlling for fund returns. Responding to their incentives, income fund managers tend to aggressively over-weight high dividend stocks in a low-rate environment. This behavior of “reaching for dividends” generates market impact: high dividend stocks tend to have higher prices when interest rates fall, and lower excess returns when interest rates subsequently normalize. © 2019 Elsevier B.V. All rights reserved.

Keywords: Low interest rates Monetary policy Dividends Income funds Flows

1. Introduction Since the global financial crisis, central banks around the world have been rushing to lower interest rates to uncharted territories, creating an ultra-low interest rate environment. Between December 2014 and May 2015, approximately $2 trillion long-term sovereign debt was trading at negative yields (Bank for International Settlements, 2015). In the U.S., the Federal Funds Rate hovered around zero for approximately seven years from 2009 to 2015, with long-term nominal and real interest rates (yields on 10-year Treasury notes and Treasury Inflation-Indexed Security) diminishing to merely 2.16% and 0.33% in May 2015, respectively. The depressed interest rates have received widespread attention and generated heated controversies. For instance, in Ben Bernanke’s testimony before the Senate Banking Committee in February 2013, Senator Bob Corker asserted that, by depressing investment returns for savers such as retirees, low interest rates were “throwing seniors under the bus.” These issues naturally lead to the questions: What is the impact of the prolonged period of low interest rates on investor behavior? How do changes in interest rates influence the prices of risky assets? In this paper, we study how lowered interest rates induce changes in the investment behavior of investors and the implications for asset prices and returns. A large literature in economics and finance emphasizes the important strategic role of interest-bearing securities such as bonds for investors to achieve a predictable stream of financial income to support their consumption plan (e.g., Campbell and Viceira, 2002; Modigliani and Sutch, 1966; Stiglitz, 1970). When interest rates ∗

Corresponding author. E-mail addresses: [email protected] (H. Jiang), [email protected] (Z. Sun).

https://doi.org/10.1016/j.jmoneco.2019.08.003 0304-3932/© 2019 Elsevier B.V. All rights reserved.

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Fig. 1. Household Financial Asset Allocation and Interest Rates. This figure plots the fraction of household financial assets invested in stocks and bonds (left axis) and the level of interest rates as captured by the yearly yields on 10-year Treasury notes (right axis) using the flow of funds data.

are low for a long period, however, bonds tend to lose their appeal because of the limited amount of interest income they offer. Instead, stocks that pay high dividends may become greener pastures, attracting the demand from income-seeking investors. This is because companies that pay high dividends tend to follow a sticky path of dividend payments, which renders their cash flow structures more resembling fixed-income assets than stocks with low or no dividend payments.1 This special feature of high dividend stocks can appeal to income-oriented investors when interest rates are low, giving rise to the behavior of “reaching for dividends.” We start our empirical analyses with the aggregate asset allocation decisions by households using the Flow of Funds data. Fig. 1 shows how the fractions of household financial assets invested in stocks and bonds vary with the level of interest rates. It illustrates the importance of interest rates in driving household financial asset allocations. For instance, accompanying the upward trend in interest rates from the 1960s, household allocation to bonds increased at the expense of that to stocks; when interest rates trended down from the 1980s, stocks re-attracted the financial wealth of households and triumphed over bonds in the late 1990s.2 To directly measure how investor demand for high dividend stocks varies with interest rates, we study the behavior of equity income funds, an important class of investors holding a large portfolio of dividend-paying stocks. As shown by French (2008), in the past decades households have been increasingly relying on asset managers such as mutual funds to invest their financial capital. A detailed examination of income fund behavior allows us to not only directly study the demand for high dividend stocks, but gain insights into the incentives to invest in high dividend stocks under delegated portfolio management. In aggregate, we find that mutual fund investors tend to send disproportionately more money to income funds when interest rates are low: from 1970 to 2014, a 1% decrease in interest rates is associated with a 0.34% increase in flows into income funds (a 0.26% increase in the excess flows into income funds over those into all equity funds). For individual income funds, when interest rates are low, flows are sensitive not only to fund returns but also to their dividend yields, with high dividend-yielding funds attracting more inflows. The resulting incentive for income fund managers appears to encourage them to tilt their portfolio more toward high dividend stocks in a low interest rate environment. These results show that income investors exhibit a stronger demand for high dividend stocks when low interest rates render bonds a less attractive savings vehicle, thereby reaching for dividends. What is the impact of time-varying investor demand for high dividend stocks on their prices and returns? Since the demand of income investors for high dividend stocks tends to be sensitive to interest rate movements, it is reasonable to believe that their prices may have a high interest rate sensitivity, increasing more when falling interest rates drive up investor demand. Before proceeding to empirical analyses, we shall note that the standard textbook theory predicts that since high dividend stocks tend to have shorter cash flow duration, their prices are less sensitive to interest rate movements than those of low dividend stocks.3 To gain intuition, we may view a common stock as a claim to a portfolio of future

1 For instance, Floyd et al. (2015) reports that industrial firms tend to pay stable dividends, with strong growth after 2002, and banks tend to follow an even more stable dividend policy. Even during the financial crisis, banks are reluctant to cut dividends. In 2008, aggregate bank dividends exceeded aggregate bank earnings by 30%. 2 The strong association between interest rates and household asset allocations to stocks and bonds remains strong after we control for the valuation effects induced by changes in stock and bond prices. 3 The use of cash flow duration to characterize an asset’s interest rate risk, i.e., dollar duration, dates back to Macaulay (1938) and Hicks (1939). Defined as the weighted-average maturity of an asset’s payoff stream, cash flow duration tightly connects the time-shape of the stream of the asset’s payoffs to the

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cash flows like a series of zero-coupon bonds. High-growth firms tend to have lower current dividend payouts but higher dividend growth rates, which skew the distribution of their cash flows towards the more distant future. In contrast, firms with higher dividend payouts tend to have lower retention ratios and lower dividend growth rates; the distribution of their cash flows is relatively denser in the nearer future. The implied cash flow duration of high dividend stocks is therefore shorter. Due to the power of compounding, the value of assets loaded with cash flows distributed in the distant future tends to be more sensitive to fluctuations in interest rates than that of assets laden with near-term cash flows. Hence, standard theory predicts that the prices of high dividend stocks tend to be less sensitive to interest rate fluctuations. To empirically examine the distinct prediction of the hypothesis of reaching for dividends, we form portfolios of stocks on the basis of their dividend to price ratios, i.e., dividend yields, and estimate their interest rate risk as the percentage price increase associated with a one-percent decline in interest rates (e.g., yields on 10-year Treasury notes). The results indicate that during the period from 1963 to 2014, ceteris paribus, when interest rates decline by 1.00%, stocks with high dividend yields tend to experience an increase in returns by 1.35%, whereas those with low dividend yields tend to have a decrease in returns by 1.11%, with both effects statistically significant at the 1% level. The difference in interest rate sensitivities between high and low dividend stocks is 2.46 with high statistical significance. A similar pattern appears, when the dividend payout ratio (dividends divided by book equity) is used as an alternative measure of dividend payments. As an illustration, Fig. 2 shows the market-adjusted returns on stocks with high and low dividends during the episode of the “taper tantrum” when bond yields rise upon the press conference by Ben Bernanke after the FOMC meeting on 19 June 2013. The prices of high dividend stocks plummeted more than those of low dividend stocks, which provides further support to our regression results. Inspired by this natural experiment, we examine the behavior of the prices of high and low dividend stocks during the two days around all the scheduled FOMC meetings from 1994 to 2014, and find a consistent pattern.4 To strengthen the identification, we exploit a natural experiment that allows us to hold across-firm variation constant, but to focus on the unique relation between cash dividends and interest rate sensitivity. In particular, Citizens Utilities historically had a dual share class structure for its common stock: Series A that pays stock dividends and Series B that pays cash dividends. According to Long (1978), this dual share class structure has two special features: The two shares must pay dividends of equal fair value; Series A shares were convertible, one-for-one, into Series B shares except between the declaration and record dates of a dividend to Series B shares. The results show that the price ratio of the two shares, albeit with no exposures to various stock market factors, is sensitive to interest rate movements, with the relative price of the cash dividend shares increasing when interest rats fall. These results reinforce the finding that high dividend stocks are particularly sensitive to interest rate fluctuations. They also highlight a distinct role of cash dividends in driving investor demand, which is different from that of capital gains. Does the price increase of high dividend stocks associated with lower interest rates reverse when they subsequently normalize? We find that lower interest rates predict lower long-horizon returns on high dividend stocks, which is consistent with stock price reversal. This return predictability is economically meaningful and statistically robust to controlling for the (Stambaugh, 1999) bias and various statistical techniques of estimating standard errors. For low dividend stocks, on the other hand, there is no such return predictability associated with interest rate movements. Having established the behavior of reaching for dividends and its impact on asset prices, we turn to its microfoundations. The literature on dividend policy and dividend clientele has provided a rich menu of possible microfoundations of investor preferences for cash dividends. The factors explored in this literature range from capital market frictions such as transaction costs and taxes (e.g., Elton and Gruber, 1970; Graham and Kumar, 2006), to investor psychological factors such as selfcontrol, regret avoidance, and mental accounting (e.g., Shefrin and Statman, 1984; Shefrin and Thaler, 1988; Thaler, 1999), and free dividend fallacy (Hartzmark and Solomon, 2018). We designed a number of statistical tests to examine the relative importance of these hypotheses in driving investor preference for dividends in our data set. Although they do not necessarily exclude a particular factor from playing a role in generating investor preferences for cash dividends, the results are most consistent with the consumption-oriented behavioral biases such as self-control, regret avoidance, and mental accounting. The novel features of this study are twofold: First, it examines how the strength of investor preference for cash dividends varies with the interest rate environment; Second, it studies how individual investors’ time-varying preference for cash dividends induces professional asset managers to change their portfolios due to the force of competition. The interaction of behavioral biases and institutional environment provides a better understanding of the impact of interest rate fluctuations on asset prices, which is an important transmission mechanism of monetary policy. The rest of this article is organized as follows. Section 2 reviews the related literature and describes our sample. Section 3 presents evidence on the behavior of investors reaching for dividends based on income funds. Section 4 shows the asset pricing impact of reaching for dividends. Section 5 explores the microfoundations for dividend clientele. Section 6 concludes.

elasticity of its present value for interest rate changes. Thanks perhaps to its conceptual and analytical power, cash flow duration is a dominant measure of interest rate risk for fixed income assets. 4 In the Internet Appendix, we perform a more systematic study of interest rate risk for high and low dividend stocks during the two days around all the scheduled FOMC meetings during the period 1994–2014. The results based on this higher-frequency identification provide further support that high dividend stocks are more sensitive to interest rate movements.

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Fig. 2. Market Adjusted Returns to High Dividend Stocks during Taper Tantrum. This figure shows the market adjusted returns for high and low dividend stock portfolios during the episode of taper tantrum. The yields on 10-year Treasury notes jumped from 2.20% to 2.33% from 18 June to 19 June 2013. To form dividend yield portfolios, we rank stocks into quintiles based on their dividend to price ratios (Panel A) or dividend to book equity ratios (Panel B) at the end of June of 2012 and hold the portfolio until the end of June of 2013. The graph shows the one-day value-weighted portfolio return in excess of the CRSP value-weighted stock market return on 19 June 2013.

2. Related literature and sample construction This section discusses the related literature and describes our sample. 2.1. Related literature This research is connected to the literature on several fronts. First, there is a large literature that studies the macroeconomic risk exposures of stocks, such as their exposures to interest rate risk. This literature, however, tends to focus on the interest rate risk of financial institutions such as banks. The leading framework is to connect interest rate risk to the balance sheet composition of these institutions. In this paper, we examine the interest rate risk for the broad cross-section of stocks; our contribution is to change the focus to time-varying investor demand driven by changes in interest rates to understand the interest rate risk of financial assets. Second, a growing number of studies report the behavior of “reaching for yield” by investors in the bond market (e.g., Becker and Ivashina, 2015; Hanson and Stein, 2015). This literature has focused on the incentives of risk taking as the driving force of investor behavior. For instance, when interest rate is low, investors may have a stronger incentive to invest in riskier bonds to reap higher yields. Our study on the behavior of reaching for dividends in the stock market suggests that risk taking may not be the only driving force of investor behavior. Instead, if there is a common underlying force that drives investor Please cite this article as: H. Jiang and Z. Sun, Reaching for dividends, Journal of Monetary Economics, https://doi.org/10. 1016/j.jmoneco.2019.08.003

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behavior in different asset markets, their desire to reach for higher income across asset markets when interest rate is low may be a compelling candidate. The empirical support for the consumption-oriented behavioral force leading to the behavior of reaching for dividends suggests the possibility of a unified theory of reaching for yield and reaching for dividends. Future research might benefit from examining investor behavior in the stock and bond markets in a common framework. Third, our paper adds to the literature that studies dividend clientele. Extending Miller and Modigliani (1961) that views dividends and capital gains as fungible in perfect and efficient capital markets, this literature argues that dividend clientele may exist due to taxes, trading costs, and behavioral reasons (e.g., Baker et al., 2007; Graham and Kumar, 2006; Hartzmark and Solomon, 2018). Moreover, investors’ sentiments for dividends may impact the valuation of dividend stocks, which may drive firms’ dividend policies and account for the appearing and disappearing dividends (Baker and Wurgler, 2004). Our result enriches this literature by showing interest rates as an important driver of the time-varying investor demand for dividends. It also helps to illuminate recently discovered dividend-related anomalies, e.g., the higher average returns to high dividend stocks during months of dividend payments (Hartzmark and Solomon, 2013), and the behavior of certain mutual funds buying stocks right before the dividend payment dates and selling them afterwards, engaging the so-called ‘juicing’ behavior (Harris et al., 2015). A notable difference between their studies and our paper is their focus on the strategy of dividend capture in the dividend paying month, whereas we consider high dividend payouts as a stock characteristic favorable to income-oriented investors. Moreover, we show that the higher interest rate sensitivity of high dividend stocks is pronounced on the short window around the FOMC meetings, which is unlikely to be driven by investor behavior around the firm-level ex-dividend days. In a subsequent study, Daniel et al. (2018) provide independent evidence for cash dividends as an important characteristic driving investor portfolio choice. Fourth, in relation to studies on the comovement between stocks and bonds, our paper examines the interconnection between stock and bond markets by explicitly considering investor demand for different asset classes as substitutes (e.g., Baele et al., 2010; Baker and Wurgler, 2012; Campbell et al., 2016). The excess comovement between high dividend stocks and interest rates is related to the broader literature on asset price comovement (e.g., Anton and Polk, 2014; Barberis et al., 2005). Fifth, our paper is related to the literature on interest rate risk and cash flow duration. It builds on the earlier studies on the interest rate elasticity of stock prices. For instance, Haugen and Wichern (1974) provide an analytic framework for interest rate elasticity of both bonds and stocks. They recognize that the notion of cash flow duration can be quite useful for understanding movements in bond and stock prices. Our study can be viewed as using their analytic results to empirically study important drivers of the behavior of dollar duration. Lanstein and Sharpe (1978) and Cornell (1999) emphasize the connection between stock market beta and dollar duration, and point to the importance of controlling for the exposures to aggregate stock market when empirically estimating dollar duration as interest rate risk. More recent studies, such as Dechow et al. (2004) and Weber (2016) construct measures of implied cash flow duration for individual firms based on their cash flow distribution. Their focus is on the cross-sectional distribution of stock returns associated with implied cash flow duration. Also related, several authors have proposed cash-flow-duration-based explanations for the value premium (e.g., Lettau and Wachter, 2007). We do not study the equilibrium premiums associated with cash flow and discount rate risks. Instead, we focus on the empirical determinants of interest rate risk. 2.2. Sample construction Our sample includes common stocks listed on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and National Association of Securities Dealers Automated Quotations (NASDAQ) during the period from July 1963 to December 2014, as available from the Center for Research in Security Prices (CRSP). Consistent with prior literature, we require the CRSP share codes to be either 10 or 11 and exclude stocks with prices below $5 as of the portfolio formation date. Accounting data such as dividends to common shareholders are from the Compustat. Macroeconomic data such as the Treasury bond yields come from the Federal Reserve Economic Data (FRED) maintained by the St. Louis Fed. Our main proxy for interest rates is the yield on 10-year Treasury notes.5 Our mutual fund holdings data come from the SEC N-30D filings, collected by the Thomson Reuters. Mutual fund returns, flows, dividends and other fund-specific information come from the CRSP. Bond return data come from Bloomberg. Data on stock return factors and risk-free rates are from Kenneth French. 3. Reaching for dividends: evidence from income funds During the past three decades, households have increasingly relied on pooled investment vehicles such as mutual funds to access the stock market. Against this backdrop, income-oriented equity funds provide a convenient and efficient tool for income-oriented investors to access a large portfolio of high dividend stocks.

5 Our results are insensitive to the choice of interest rate proxies. We also have used the yield on 5-year Treasury notes as an alternative measure of the interest rates and obtained qualitatively similar results. For even longer maturities, the U.S. Treasury discontinued the 20-year constant maturity series at the end of calendar year 1986 and reinstated that series on October 1, 1993. As a result, there are no 20-year rates available for the time period January 1, 1987 through September 30, 1993. Similarly, 30-year Treasury constant maturity series was discontinued on February 18, 2002 and reintroduced on February 9, 2006. We therefore focus on the yield on 10-year Treasury notes.

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This section studies the incentive and behavior of income funds, to more closely examine the demand for high dividend stocks. It proceeds in three steps. First, we look at how the aggregate flows into and out of income funds vary with interest rates. If households have a stronger preference for high dividend-yielding assets when interest rates are low, we would expect the aggregate flows into equity income funds to correspondingly rise. Panel A of Table 1 provides evidence consistent with this conjecture. It shows a strong comovement between flows to income-oriented equity funds and interest rates. Column 1 shows that when interest rates fall by 1%, flows into income funds increase by 0.34%, which is statistically significant. Column 3 indicates that there is also an increase in flows into equity funds in general when interest rates fall; the magnitude, however, is much smaller. As a result, Column 5 shows that the flows into income funds in excess of those into all equity funds are highly sensitive to interest rate movements: when increase rates decline by 1%, the excess flows into income funds increase by 0.26%, which is statistically significant. This relation between flows of income funds and interest rates appear fairly robust; controlling for past returns to income funds and equity funds as a group has virtually no impact on this relation. Next, we examine the flow-performance relation across income funds, to better understand the incentive of income fund managers. The idea is that if investors desire high dividend yields when interest rates are low, funds that register higher dividend yields may attract more money from their client, even after controlling for the influence of total fund return. Panel B of Table 1 provides evidence consistent with this conjecture. It reports the flow-performance relation for individual income funds, using past fund return and dividend yield as performance measures. A fund’s dividend yield is measured by the ratio between the amount of dividend distribution and the fund’s Net Asset Value (NAV) at which the dividends can be reinvested. To capture the dependence of the flow-performance relation on the level of interest rates, we include interaction terms between the two performance measures and interest rates. The results reveal a dynamic relation between income fund flows and performance. As shown in Column 1, on average past fund return and dividend yield drive income fund flows, with higher performing funds attracting more inflows. Different from their returns, an income fund’s dividend yield has a time-varying impact on investor flows. Columns 2 and 3 show that when interest rates go down, high dividend-yielding income funds tend to be particularly attractive, receiving higher inflows than low dividend funds with similar fund returns. In terms of magnitudes, when interest rates fall below their median level, an income fund registering a dividend yield 1% higher than an otherwise similar fund in the previous quarter attracts additional inflows of 2.445% (2.499 − 0.054 = 2.445) in the subsequent quarter. When interest rates are above their median level, the relation between an income fund’s dividend yield and investor flows is statistically indistinguishable from zero after controlling for other fund characteristics. Column 4 further shows that when interest rates are extremely low, falling below the bottom quintile, investors tend to allocate less attention to fund returns, but more to dividend yield in their fund investment decisions. These results provide strong support for the view that mutual fund investors reward income-oriented mutual funds with high dividend yields by switching more money to those funds, when interest rates are low. How do income fund managers respond to this incentive? Our last analysis examines how income funds’ portfolio composition changes with interest rates. We start by sorting stocks into five groups based on their dividend yield, and then compute the weight of each dividend quintile in the fund portfolio in excess of that in the market portfolio. This excess portfolio weight captures the extent of portfolio tilt by income fund managers. Panel A of Table 2 presents the results over the period 1980–2014. Column 1 shows that on average income funds overweight the stocks in the top dividend yield quintile by 3% and those in the second highest quintile by 6.8%. In contrast, they on average underweight stocks in the bottom dividend yield quintile by 8.1%. More interestingly, the allocation between high and low dividend yield stocks by income funds appears to depend on the level of interest rates. When interest rates are low, we find that income funds exhibit even stronger preferences for holding high dividend stocks: They overweight stocks in the top quintile with the highest dividend yield by 4.5%, and overweight stocks in the second highest dividend yield quintile by 9.3%. When interest rates are high, however, income funds tend to be more reluctant to overweight high dividend stocks. In fact, they underweight stocks in the top quintile with the highest dividend yield by 1.3%, and reduce the overweighting of stocks in the second highest dividend yield quintile to 5%. This dynamic shift of the strength of preferences for high dividend stocks by income funds provides direct evidence for timevarying dividend clientele, supporting the hypothesis of reaching for dividends. A stock’s dividend yield tends to be correlated with other attributes such as the earnings-to-price (E/P) and book-tomarket (B/M) ratios. Is it possible that our preceding results may be driven by the tendency of income fund managers to prefer firms with higher earnings or their strategic tilt away from growth to value firms, when interest rates are low? To address this question, we perform sequential sorts to tease out the incremental effect of dividend yield relative to E/P and B/M on income fund investment decisions. Panels B and C of Table 2 show the results. In the left three columns of each panel, we first sort stocks into quintile portfolio based on the E/P (B/M) and then within each E/P (B/M) portfolio sort stocks into quintile portfolio based on D/P. We then combine the portfolios with the same D/P ranking into one. For instance, “Low Dividends” portfolio represents the stocks with the lowest 20% dividend yield in each of the 5 E/P (B/M) portfolios. We then calculate income funds’ excess weights in each of the dividend portfolios for low and high interest rate period. In the right three columns, we reverse the sorting order, by first sorting on D/P and then sorting on E/P (B/M). Our results indicate that after controlling for E/P or B/M, income funds tend to exhibit higher portfolio tilts toward high dividend stocks when interest rates are low. On the other hand, after controlling for the dividend yield, there is no evidence that income funds tend to tilt their portfolios toward high E/P or B/M stocks when interest rates are low. These results support the hypothesis

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Table 1 Income Fund Flows and Interest Rates. This table reports the relations between flows into income funds and interest rates from 1970 to 2014. Panel A shows the aggregate relation and Panel B the fund-level flow-performance relation. InterestRate is the yield on 10-year Treasury notes. In Panel A, the dependent variable for Columns 1–2 (3–4) is F lowIncome , the quarterly flow of aggregate income-oriented equity funds (F lowEquity , the quarterly flow of aggregate equity funds); that for Columns 5–6 is F lowIncome−Equity , the difference between F lowIncome and F lowEquity . RIncome , REquity , and RIncome−Equity represent the returns in the past quarter to income funds, equity funds and the difference between the two, respectively. The t-statistics in parentheses are based on heteroskedasticity-consistent standard errors. In Panel B, we separately examine the effects of fund returns (RFund ) in the past quarter and their dividend yield (YieldFund ) on the current-quarter flows. YieldFund is the ratio between the amount of dividend distribution and the NAV at which the dividends can be reinvested. We also include interaction terms between the performance measures and InterestRate in percent. In column 3 and 4, LowRate is an indicator variable that takes a value of 1 if interest rates during the quarter are among the lowest 50% and 20% over the entire sample period, respectively. Past f low is the flow over the past quarter. We conduct panel regression with time fixed effects. The standard errors are clustered on the fund share class level. ∗ ∗ ∗ stands for statistical significance at the 1% level; ∗ ∗ 5%; and ∗ 10%. Panel A: Aggregate evidence

InterestRate

(1) F lowIncome

(2) F lowIncome

(3) F lowEquity

(4) F lowEquity

(5) F lowIncome−Equity

(6) F lowIncome−Equity

−0.342∗ ∗ ∗ (−7.56)

−0.348∗ ∗ ∗ (−7.50) 0.0370∗ ∗ (2.04)

−0.0823∗ ∗ (−1.99)

−0.0879∗ ∗ (−2.13)

−0.260∗ ∗ ∗ (−5.71)

−0.257∗ ∗ ∗ (−5.87)

0.0160∗ ∗ ∗ (4.37) 180 0.154

0.291∗ ∗ (2.54) 0.0158∗ ∗ ∗ (4.55) 180 0.282

RIncome

0.0346∗ ∗ ∗ (2.67)

REquity RIncome−Equity Intercept # of Obs. Adj.R2

0.0255∗ ∗ ∗ (6.81) 180 0.144

0.0249∗ ∗ ∗ (6.54) 180 0.152

0.00949∗ ∗ ∗ (3.53) 180 0.00746

0.00896∗ ∗ ∗ (3.34) 180 0.0228

(1)

(2)

(3)

(4)

1.098∗ ∗ ∗ (11.39) 1.558∗ ∗ ∗ (2.84)

0.874∗ ∗ ∗ (2.82) 5.727∗ ∗ ∗ (3.45) 0.043 (0.76) −0.792∗ ∗ ∗ (−2.93)

1.165∗ ∗ ∗ (7.38) −0.054 (−0.08)

1.224∗ ∗ ∗ (10.79) 0.378 (0.64)

−0.102 (−0.54) 2.499∗ ∗ ∗ (2.74) 0.217∗ ∗ ∗ (17.75) −3.574∗ ∗ ∗ (−7.06) 0.001 (0.11) −0.018∗ ∗ ∗ (−11.50) −0.051∗ ∗ ∗ (−15.45) −0.025 (−0.17) 0.006∗ ∗ ∗ (5.63) 0.253∗ ∗ ∗ (5.49) 0.317∗ ∗ ∗ (12.40) Y 34,173 0.187

−0.479∗ ∗ (−2.19) 4.070∗ ∗ ∗ (3.19) 0.217∗ ∗ ∗ (17.70) −3.550∗ ∗ ∗ (−7.07) 0.000 (0.02) −0.018∗ ∗ ∗ (−11.54) −0.050∗ ∗ ∗ (−15.38) −0.058 (−0.40) 0.006∗ ∗ ∗ (5.63) 0.253∗ ∗ ∗ (5.48) 0.305∗ ∗ ∗ (11.82) Y 34,173 0.188

Panel B: Fund-level evidence

RFund YieldFund RFund × InterestRate YieldFund × InterestRate RF und × LowRate Y ieldF und × LowRate PastF low Expense T ur nover Log(FundAssets) Log(FundAge) Volatility Log(FamilyAssets) PastF amil yF l ow Intercept Time Fixed Effects # of Obs. Adj.R2

0.217∗ ∗ ∗ (17.76) −3.582∗ ∗ ∗ (−7.09) 0.001 (0.25) −0.0182∗ ∗ ∗ (−11.46) −0.051∗ ∗ ∗ (−15.51) −0.006 (−0.04) 0.006∗ ∗ ∗ (5.57) 0.253∗ ∗ ∗ (5.47) 0.322∗ ∗ ∗ (12.66) Y 34,173 0.187

0.217∗ ∗ ∗ (17.73) −3.562∗ ∗ ∗ (−7.05) 0.000 (0.07) −0.018∗ ∗ ∗ (−11.52) −0.051∗ ∗ ∗ (−15.44) −0.041 (−0.28) 0.006∗ ∗ ∗ (5.64) 0.254∗ ∗ ∗ (5.50) 0.310∗ ∗ ∗ (11.97) Y 34,173 0.187

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H. Jiang and Z. Sun / Journal of Monetary Economics xxx (xxxx) xxx Table 2 Reaching for Dividends When Interest Rates are Low: Income Funds. This table reports income fund portfolio weights in excess of the market weight for stocks with different levels of dividend yield. In each quarter, we sort stocks into quintile portfolio based on its dividend-price ratio (D/P) at the beginning of year. We calculate the weights of each portfolio in the income fund portfolio in excess of those in the market portfolio. In Panel A, we report the time-series average of the excess weights for the whole sample period, as well as the average excess weights during different interest rate regimes. High and low interest rate periods are top and bottom 20% of quarters ranked on the basis of long-term interest rates as measured by the yields on 10-year Treasury notes. In Panel B, we compare the preferences of income funds for high dividend stocks versus high earnings stocks. In the left three columns, we first sort stocks into quintile portfolio based on the earnings-price (E/P) ratio and then within each E/P portfolio sort stocks into quintile portfolio based on D/P. We then combine the portfolios with the same D/P ranking into one. For instance, “Low Dividends” portfolio represents the stocks with the lowest 20% dividend yield in each of the 5 E/P portfolios. We then calculate income funds’ excess weights in each of the dividend portfolios for low and high interest rate period. In the right three columns, we reverse the sorting order, by first sorting on D/P and then sorting on E/P. In panel C, we conduct a similar analysis as in Panel B, using the book-to-market (B/M) ratio. ∗ ∗ ∗ stands for statistical significance at the 1% level; ∗ ∗ 5%; and ∗ 10%. Panel A: Univariate sorts on D/P Interest rate regime

Low Dividends 2 3 4 High Dividends

Whole sample

Low

2

3

4

High

High–Low

−0.081 (−25.79) −0.034 (−13.00) 0.016 (5.80) 0.068 (32.08) 0.03 (8.48)

−0.103 (−41.22) −0.063 (−17.45) 0.029 (4.65) 0.093 (19.90) 0.045 (12.28)

−0.112 (−20.52) −0.027 (−4.04) 0.03 (4.97) 0.053 (17.42) 0.056 (8.63)

−0.09 (−9.45) −0.035 (−8.57) 0.02 (3.08) 0.07 (20.15) 0.036 (14.37)

−0.061 (−20.84) −0.033 (−7.23) −0.013 (−2.33) 0.067 (17.85) 0.04 (7.05)

−0.042 (−15.06) −0.008 (−2.32) 0.01 (2.08) 0.05 (18.38) −0.013 (−1.48)

0.061∗ ∗ ∗ (16.31) 0.055∗ ∗ ∗ (10.78) −0.019∗ ∗ (−2.46) −0.039∗ ∗ ∗ (−7.06) −0.058∗ ∗ ∗ (−5.98)

High—Low

Earnings

Low rate

High rate

High—Low

0.057 (13.29) 0.048∗ ∗ ∗ (10.22) 0.028∗ ∗ ∗ (4.36) −0.078∗ ∗ ∗ (−12.81) −0.056∗ ∗ ∗ (−6.52)

Low

−0.027 (−7.76) 0.012 (2.42) −0.005 (−1.31) 0.016 (4.95) 0.004 (0.84)

−0.014 (−6.05) −0.004 (−1.30) −0.015 (−6.87) 0.013 (5.07) 0.021 (6.19)

0.013∗ ∗ ∗ (3.09) −0.016∗ ∗ ∗ (−2.75) −0.011∗ ∗ (−2.53) −0.004 (−0.86) 0.017∗ ∗ ∗ (3.18)

High–Low

B/M

Low Rate

High Rate

High–Low

Low

−0.028 (−7.50) 0.005 (2.31) 0.012 (4.91) 0.013 (4.48) −0.001 (−0.49)

−0.063 (−10.24) −0.024 (−6.28) 0.019 (7.33) 0.044 (8.64) 0.024 (12.14)

−0.035∗ ∗ ∗ (−4.86) −0.029∗ ∗ ∗ (−6.60) 0.007∗ ∗ (2.08) 0.032∗ ∗ ∗ (5.38) 0.025∗ ∗ ∗ (8.07)

Panel B: Sequential Sorts on D/P and E/P Sorting First on E/P Dividends Low 2 3 4 High

Low rate −0.085 (−25.59) −0.047 (−12.61) −0.013 (−3.09) 0.091 (18.10) 0.054 (15.14)

High rate −0.028 (−10.05) 0.001 (0.18) 0.015 (3.10) 0.013 (3.90) −0.001 (−0.14)

Sorting First on D/P

∗∗∗

2 3 4 High

Panel C: Sequential Sorts on D/P and B/M Sorting First on B/M Dividends Low 2 3 4 High

Low Rate −0.084 (−24.65) −0.05 (−13.38) −0.007 (−1.55) 0.081 (13.43) 0.061 (20.09)

High Rate −0.017 (−6.83) 0.002 (0.66) 0.036 (11.73) 0.017 (5.54) −0.038 (−6.08)

Sorting First on D/P

∗∗∗

0.068 (15.98) 0.051∗ ∗ ∗ (11.38) 0.043∗ ∗ ∗ (7.73) −0.063∗ ∗ ∗ (−9.36) −0.099∗ ∗ ∗ (−14.20)

2 3 4 High

of investors reaching for dividends when interest rates are low, but do not support the behavior of reaching for earnings or reaching for value.

4. Reaching for dividends: impact on asset prices What is the impact of time-varying investor demand for high dividend stocks on their prices and returns? Since the demand of income investors for high dividend stocks tends to be sensitive to interest rate movements, as we have shown, it is reasonable to believe that they may have higher interest rate risk, with prices increasing more when interest rates trend Please cite this article as: H. Jiang and Z. Sun, Reaching for dividends, Journal of Monetary Economics, https://doi.org/10. 1016/j.jmoneco.2019.08.003

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Table 3 Dollar Duration Estimates for Dividend Sorted Portfolios. This table shows the estimates of dollar duration for high and low dividend stocks over the period July 1963 to December 2014. Dollar duration is estimated as the negative of the slope coefficients for changes in yields on 10-year Treasury notes from regressions of excess stock returns on changes in yields and stock market return factors. In the specification for $Duration 1, we include excess aggregate stock market return; in that for $Duration 2, we include excess market returns, the Fama and French (1993) size and value factors, and the Jegadeesh and Titman (1993) momentum factor. In Panel A (B), high and low dividend stocks refer to stocks in the top and bottom 20% of stocks ranked on the dividend to price (dividend to book equity) ratios. We compute value-weighted return on portfolios formed at the end of each June from 1963 and rebalanced at the end of next June. The t-statistics are in parentheses. ∗ ∗ ∗ stands for statistical significance at the 1% level; ∗ ∗ 5%; and ∗ 10%. Low dividends

High dividends

High—Low

1.008 (3.71) 0.572 (2.76)

1.348 (3.53) 0.694 (2.67)

2.460∗ ∗ ∗ (4.70) 1.605∗ ∗ ∗ (4.18)

0.396 (1.69) 0.108 (0.53)

0.873 (3.53) 0.543 (2.77)

1.851∗ ∗ ∗ (4.50) 1.403∗ ∗ ∗ (3.93)

Panel A: Dividend yield D/P $Duration1 $Duration2

−1.112 (−4.49) −0.911 (−3.93)

0.0726 (0.30) −0.0724 (−0.31)

0.598 (2.42) 0.323 (1.45)

Panel B: Dividend payout D/BE $Duration1 $Duration2

−0.978 (−3.47) −0.861 (−3.18)

−0.628 (−2.67) −0.653 (−2.91)

0.454 (2.23) 0.285 (1.55)

down, driven by higher investment demand. In this section, we explore the implications of investors reaching for dividends for stock prices and returns.

4.1. Baseline results: high interest rate risk of high dividend stocks We estimate the interest rate risk (dollar duration) for an asset i by performing the following regression:

Ri,t − R f,t = α + $Duration × (−It ) + β × Ft + i,t ,

(1)

where Ri,t is the return to asset i in month t, Rf,t is the one-month Treasury bill rate in month t, It is the change in longterm interest rates, and Ft is the return to stock market factor in month t. Consistent with the convention in bond duration, we use the negative of It in our regression so that our $Duration estimate can be interpreted as the percentage decrease in prices associated with a one-percent increase in interest rates. In our baseline specification, we use the excess return to the aggregate stock market portfolio as the return factor. We augment the market factor with the size and value factors from the Fama and French (1993) model and the Jegadeesh and Titman (1993) momentum factor as an alternative specification. We start by estimating how the interest rate sensitivity of stock prices is related to their dividend payouts. To reduce the estimation error, we follow the standard approach in the asset pricing literature by estimating stock dollar duration on portfolio levels. Specifically, at the end of each June from year 1963 to year 2014, stocks are sorted into quintile portfolios based on their dividend to price ratios (or dividend to book equity ratio) measured at the most recent fiscal year end. We compute the value-weighted returns for each quintile portfolio, and then estimate the dollar duration of each portfolio by performing regression (1). Table 3 presents the estimation results. Although the intuition from the dividend discount model predicts a negative association between dollar duration and dividend yield, the results indicate that interest rate sensitivity increases monotonically with dividend yields. For instance, after controlling for the market factor, the returns on the high dividend stocks in Quintile 5 decrease by 1.35% when long-term bond yields increase by 1%, whereas the returns on the low dividend stocks in Quintile 1 increase by 1.11%. The difference in dollar duration between the high and low dividend stocks is 2.46, both economically large and statistically significant. The result is robust when the dividend to book equity ratio is used to form portfolios. We shall note that the high dollar duration of high dividend stocks does not simply reflect their high exposures to movements in the aggregate stock market. All the regressions in Table 3 control for the variation in stock market returns. Moreover, in the alternative specification ($Duration2 ), we control for the influence of other systematic factors such as the size, value, and momentum factors. Internet Appendix includes further robustness tests to establish the higher interest rate risk of higher dividend-paying stocks, using the Fama and French 5-factor model and considering economic recessions. It also considers alternative explanations such as cash flow risk, distance to default, flight to safety, industry effects, financial and operating leverage, and inflation. Please cite this article as: H. Jiang and Z. Sun, Reaching for dividends, Journal of Monetary Economics, https://doi.org/10. 1016/j.jmoneco.2019.08.003

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4.1.1. Dividend growth rates and macroeconomic conditions Different from fixed-income securities, the cash flows of stocks can vary with interest rates. If a stock’s dividend growth rate is correlated with interest rates, then the dollar duration of high dividend stocks depends on the joint effects of current dividend yield and the influence of interest rates on future dividend growth rates. Intuitively, when a fall in interest rates leads to a large increase in dividend growth rates of high dividend stocks, their prices can accordingly jump up, exhibiting a large interest rate sensitivity and long dollar duration. To assess this possibility, we compute the correlation between interest rates and subsequent five-year dividend growth rates of high and low dividend stocks. The results indicate a statistically significant positive correlation between interest rates and dividend growth rates of high dividend stocks (38% and 30% for stocks with high dividend yields and high dividend payout ratios, respectively), whereas the same correlation is statistically indistinguishable from zero for low dividend stocks. These results indicate that a fall in interest rates tends to associate with a decline in dividend growth rates of high dividend stocks, which, ceteris paribus, should associate with a drop in the prices of these stocks. This positive relation between interest rates and dividend growth rates for high dividend stocks renders their large price increases when interest rates fall even more puzzling. 4.2. Dual share classes of citizens utilities: a natural experiment Despite our efforts to control for stock market and other macroeconomic risk, it is challenging to fully insulate the influence of unobserved risk factors and firm-level attributes that are associated with both dividend payouts and interest rate risk. In this subsection, we exploit a natural experiment that allows us to hold across-firm variation constant, but focus on the unique relation between cash dividends and interest rate sensitivity. From early 1956, Citizens Utilities adopted a dual share class structure for its common stock: Series A that pays stock dividends and Series B that pays cash dividends. According to Long (1978), these two share classes are almost identical, except for their dividend payout. In addition, two special features make this dual share class structure interesting for our purpose. First, “Whenever a given cash dividend per share is paid to Series B shares, stock dividends per share of equal fair value must be paid during the same calendar year to Series A share.” Second, “Series A shares would always be convertible, one-for-one, into Series B shares except between the dates of declaration and record of a dividend to Series B shares” (pp. 237). Essentially, the contractual ties of the cash flows for the two share classes would guarantee that, in a fully rational, perfect capital market, these two share classes would trade at the same market price. Long (1978) provides evidence against this conjecture. He finds that over the period 1956–1976, Series B on average commands a price premium over Series A, which suggests that the stock market on average values cash dividends higher than capital gains over this sample period. Building on Long’s study, we focus on the time-series movements of the price ratio of Series B to A. Since there is no cash flow difference between the two share classes, the price difference between them captures the difference in investor preferences for cash dividends against capital gains. In what follows, we examine how interest rates are related to this price ratio. Since Series A pays semi-annual dividends and Series B pays quarterly dividends, we use the strategy proposed by Long (1978) to synchronize the dividend payments for these two securities. Specifically, we compute an adjusted price for Series B, assuming that all cash dividends are reinvested into Series B shares; the cumulative gains are paid out as cash dividends during the month when Series A pays stock dividends. In other words, if Series A goes ex-dividend in month t, a = P ; otherwise, P a = P PB,t B,t B,t−1 × (1 + RB,t ), where RB,t is the total return to Series B in month t. The sample period is B,t from June 1973 to December 1989.6 Table 4 presents the regression results of log(PBa /PA ) on interest rates and stock market factors. The results indicate a large interest rate risk of Series B, after the cash flow risk is removed. For instance, Column 1 shows that when interest rates go down by 1.00%, the relative price of Series B goes up by 0.89%, after we control for the aggregate stock market return. This effect is statistically significant with a t-statistic of 3.91. Similar results are obtained when we expand the set of stock market factors in Columns 2 and 3. Consistent with the price ratio well eliminating cash flow risk, the loadings of this price ratio on all the stock market factors are statistically indistinguishable from zero. In Columns 4 to 6, changes in interest rates are used as the independent variable. The results show a similarly negative relation. These results reinforce the finding that high dividend stocks are particularly sensitive to interest rate fluctuations. They also highlight a distinct role of cash dividends in driving investor demand, which is different from that of capital gains.7 4.3. Return predictability We have shown that prices of high dividend stocks are particularly sensitive to changes in interest rates, consistent with investor demand shocks moving the prices of high dividend stocks. This test focuses on contemporaneous relations between changes in stock prices and changes in interest rates. If interest rates have a persistently downward trend, the accumulated 6 Stock price data of Citizens Utilities are available in CRSP from December 1972. The first stock dividend of Series A appeared in June 1973, which is the start of the sample period. Our sample ends in December 1989, because Series B started to pay stock dividends in 1990. 7 Poterba (1983) compares the shareholder composition of the two share classes of Citizens Utilities. He shows that smaller, perhaps less wealthy, retail investors and smaller institutions tend to be more important shareholders of Series B shares. This evidence is consistent with the hypothesis that income investors on average tend to prefer cash dividends.

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Table 4 The Price Ratio of Cash Dividend Share to Stock Dividend Share for Citizens Utilities. This table shows how interest rates influence the price ratio of Citizens Utilities’s share class B that pays cash dividends to class A that pays stock dividends in the same dollar value. Interest Rate is the 10-year Treasury yield, Interest Rate is its change. Market is the excess return on the market portfolio, SMB and HML are the Fama and French size and value factors, Momentum is the momentum factor, CMA and RMW are the Fama and French investment and profitability factors. The sample period is from June 1973 to December 1989. ∗ ∗ ∗ stands for statistical significance at the 1% level; ∗ ∗ 5%; and ∗ 10%.

Interest Rate

Interest Rate Market

(1)

(2)

(3)

−0.898∗ ∗ ∗ (−3.91)

−0.905∗ ∗ ∗ (−3.91)

−0.836∗ ∗ ∗ (−3.54)

−0.088 (−0.87)

−0.043 (−0.36) −0.081 (−0.42) 0.128 (0.62) −0.010 (−0.07)

−0.003 (−0.13) 199 0.064

−0.003 (−0.13) 199 0.053

−0.046 (−0.38) −0.108 (−0.55) −0.127 (−0.42) −0.015 (−0.10) 0.214 (0.45) −0.514 (−1.27) −0.008 (−0.35) 199 0.054

SMB HML Momentum CMA RMW Intercept Observations AdjR2

(4)

(5)

(6)

−2.553∗ (−1.94) −0.118 (−1.09)

−2.515∗ (−1.84) −0.109 (−0.83) −0.016 (−0.08) 0.022 (0.10) −0.003 (−0.02)

−0.089∗ ∗ ∗ (−16.99) 199 0.010

−0.089∗ ∗ ∗ (−15.70) 199 −0.005

−2.329∗ (−1.71) −0.102 (−0.77) −0.054 (−0.27) −0.352 (−1.15) −0.016 (−0.10) 0.410 (0.85) −0.642 (−1.56) −0.087∗ ∗ ∗ (−14.61) 199 0.007

demand for high dividend stocks may push up the valuation of high dividend stocks and reduce their future returns, leading to long-horizon return predictability. We first study the connection between the level of interest rates and the level of valuation spread between high and low dividend stocks. Specifically, quintile portfolios are formed on the basis of dividend yield, and the spread in M/B between the top and bottom quintile portfolios is computed. It is then regressed on the 10-year Treasury yield. The results in the Internet Appendix show a negative and statistically significant coefficient for interest rates. It indicates that when interest rates decrease, the high dividend stocks tend to receive a higher valuation relative to low dividend stocks. Turning to long-horizon return predictability, we examine the conjecture that a lower level of interest rates associates with lower returns on high dividend stocks. To this end, we perform predictive regressions using the 10-year Treasury yield to predict future five-year excess returns to stocks with different levels of dividend yields over the period from July 1963 to December 2009. The econometric challenges for long-horizon predictive regression are twofold: a possible finite-sample bias (Stambaugh, 1999) because interest rates are persistent, and serially dependent residuals because we use overlapping longhorizon returns to increase the statistical power. To address these challenges, we report several statistics. First, the Ordinary Least Squares (OLS) regression with Hodrick (1992) standard errors is used to deal with overlapping observations. Second, the Stambaugh bias is estimated using both the closed-form solution in Stambaugh (1999) and moving-block bootstrap procedure. Since the closed-form solution gives a larger value, it is reported as our estimate of the Stambaugh bias. Third, an alternative measure of standard errors is computed on the basis of the moving-block bootstrap procedure.8 The results of Table 5 indicate that interest rates have strong and statistically significant power to predict future excess returns on high dividend stocks. To get a sense of the magnitude, a decline in the 10-year Treasury yield by one standard deviation predicts a decrease in average annual excess returns on stocks with high dividend yield by 4.97% during the subsequent five years, with a t-statistic based on Hodrick (1992) standard errors of 2.00 and an adjusted R2 of 23.65%. Since the Stambaugh bias is small in these regressions, it has little influence on our results. Using the bootstrap technique, we report similar results. For low dividend stocks, we find no evidence of long-horizon return predictability. These results support the notion that the discount rate for high dividend stocks is driven by interest rates. 5. Exploring the microfoundations What is special about cash dividends? In the pioneering paper by Miller and Modigliani (1961), a firm’s dividend policy is irrelevant to its value in the world with perfect capital markets. The intuition is straightforward: in the idealized capital market, investors can transform dividend income to capital gains and vice versa without costs according to their own preferences; as a result, dividends play no special role in driving investor demand. For dividends to influence investor demand, 8

Technical details are provided in Internet Appendix I.

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H. Jiang and Z. Sun / Journal of Monetary Economics xxx (xxxx) xxx Table 5 Predicting Long-Run Stock Returns with Interest Rates. This table tests whether interest rates predict future returns to stock portfolios formed on the basis of dividend yields or payout ratios over the period from July 1963 to December 2014. Specifically, we sort stocks by their dividend to price ratio or payout ratio into five portfolios, and calculate their value-weighted monthly returns. We then use the yields on 10-year Treasury notes to forecast next five-year returns and excess returns on high and low dividend stock portfolios, respectively. In these regressions, the independent variable is standardized to have a mean of zero and standard deviation of one, and the dependent variable is five-year (excess) return in per cent. Hodrick T-statistics are based on the Hodrick (1992) standard errors. Bootstrapped T-statistics are based on block-bootstrapped standard errors. Adjusted Hodrick T-statistics and Adjusted Bootstrapped T-statistics adjust for Stambaugh bias in the point estimate. We describe the details of the block bootstrapping procedure in the Internet Appendix. ∗ ∗ ∗ stands for statistical significance at the 1% level based on adjusted Hodrick T-statistics; ∗ ∗ 5%; and ∗ 10%. Low dividend

High dividend

Dividend yield

Interest Rate Hodrick T-statistic Bootstrapped T-statistic Stambaugh Bias Adjusted Hodrick T-statistic Adjusted Bootstrapped T-statistic Adj R2

Return

Excess return

Return

Excess return

19.03 (1.63) (1.64) 0.30 (1.60) (1.20) 9.66

7.55 (0.64) (0.77) 0.40 (0.61) (0.46) 1.65

36.35∗ ∗ ∗ (3.05) (3.88) 0.04 (3.05) (3.79) 42.93

24.88∗ ∗ (2.00) (2.32) 0.20 (1.98) (2.28) 23.65

Return

Excess return

Payout ratio Returns Interest Rate Hodrick T-statistic Bootstrapped T-statistic Stambaugh Bias Adjusted Hodrick T-statistic Adjusted Bootstrapped T-statistic Adj R2

21.28 (1.46) (1.46) 0.34 (1.44) (1.14) 8.42

Excess return 9.80 (0.68) (0.81) 0.49 (0.65) (0.50) 1.98

∗∗∗

36.72 (3.49) (3.13) 0.14 (3.48) (2.70) 37.09

25.25∗ ∗ (2.18) (2.12) 0.29 (2.15) (1.84) 19.84

the literature proceeds along two directions: introducing market frictions such as transaction costs and taxes, or considering investor psychology. This section explores these two avenues. 5.1. Market frictions We start by considering capital market frictions, first transaction costs and then taxes. In stock markets, the transformation between income and capital gains incurs transaction costs. For an investor demanding regular income streams over a long period, e.g., a retiree who demands regular monthly income flows to finance her desired consumption plan in the next 15 years, spending the dividend stream from companies paying high dividends has clear advantages over regularly selling stock holdings with costs to raise income. Therefore, the desire to reduce trading costs can be an important reason for investors to prefer cash dividends. To examine the empirical importance of this hypothesis to the main findings, two tests are performed. First, the discrete changes in trading costs induced by regime shifts in tick size are exploited: the change from $1/8 to $1/16 implemented by June 1997 and the decimalization implemented by April 2001. In particular, we construct two indicator variables, Regime1 and Regime2 which capture the time periods from June 1997 to March 2001, and April 2001 to December 2014, respectively. If transaction costs are important in driving dividend clientele, we would expect the dollar duration estimates of high dividend stocks to be smaller in the two subperiods when transaction costs are reduced; that is, $Duration1 and $Duration2 are negative in the following regression:

Ri,t − R f,t = α + ($D + $D1 × Regime1 + $D2 × Regime2 ) × (−It ) + β × Ft + i,t . $Duration1

(2)

$Duration2

Columns 1 and 2 of Panel A of Table 6 indicate that neither nor is significantly negative in the regressions, which casts doubt on the idea that transaction costs may be of first-order importance in driving our results. The second strategy to capture time variation in transaction costs is to construct a continuous variable of market illiquidity. Following Corwin and Schultz (2012), we first construct a stock-level measure of bid-ask spreads for each month and then compute the cross-sectional average bid-ask spread as a measure of market-wide illiquidity. To test for the idea that when transaction costs decline, the importance of dividend clientele and the effect of reaching for dividends may fall, we compute the difference in dollar duration estimates between high and low dividend stocks based on rolling threeyear regressions and regress it on the average market illiquidity computed during the same three-year window. The results Please cite this article as: H. Jiang and Z. Sun, Reaching for dividends, Journal of Monetary Economics, https://doi.org/10. 1016/j.jmoneco.2019.08.003

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Table 6 Market Frictions and Reaching for Dividends. This table examines how market frictions influence the behavior of reaching for dividends. In Panel A, we construct two indicator variables Regime1 (June 1997–March 2001)and Regime2 (April 2001 to December 2014), which capture changes in trading costs induced by regime shifts in tick size: the change from $1/8 to $1/16 and the decimalization. The dependent variables are the difference in returns between high and low dividend stocks based on dividend yield (Column 1) and dividend payout ratio (Column 2). The Spread variable is the market-wide bid-ask spread, based on the technique of Corwin and Schultz (2012). The dependent variables in Columns 3 and 4 are the difference in rolling three-year dollar duration estimates between high and low dividend stocks based on dividend yield and dividend payout ratio, respectively. The average market Spread variable is computed during the same rolling three-year window. We use the Newey–West standard errors with 36 lags. In Panel B, we regress the difference in rolling three-year dollar duration estimates between high and low dividend stocks based on dividend yield (Columns 1 and 2) and dividend payout ratio (Columns 3 and 4) on average dividend tax rates and average capital gains tax rates, or their proportional difference Taxspread = (1 − Taxlcg )/(1 − Taxd ) during the past three years, available from Sialm (2009). We use the Newey-West standard errors with 3 lags. In Panel C, we use the Economic Recovery Tax Act of 1981 and 2003 dividend tax reform to divide the full sample period from 1963 to 2014. Dollar duration is estimated as the negative of the slope coefficients for changes in yields on 10-year Treasury notes from regressions of excess stock returns on changes in yields and excess aggregate stock market return. ∗ ∗ ∗ stands for statistical significance at the 1% level; ∗ ∗ 5%; and ∗ 10%. Panel A: Trading costs

Interest Rate Interest Rate × Regime1 Interest Rate × Regime2 Regime 1 Regime 2

(1)

(2)

2.304∗ ∗ ∗ (3.88) 0.991 (0.38) 0.705 (0.48) 0.00144 (0.24) −0.000190 (−0.05)

1.092∗ ∗ (2.51) 0.476 (0.25) 2.835∗ ∗ ∗ (2.65) 0.000226 (0.05) −0.00193 (−0.76)

Spread −0.00418∗ ∗ (−2.24) 618 0.215

Intercept Observations Adj R2

0.000451 (0.32) 618 0.588

(3)

(4)

−0.391∗ (−1.70) 4.855∗ ∗ ∗ (4.43) 583 0.101

−0.276 (−1.32) 3.580∗ ∗ ∗ (3.10) 583 0.063

Panel B: Dividend and Capital Gains Tax Rates (1)

(2)

(3)

∗∗

Tax_d

15.17 (2.06) −7.339 (−0.73)

Tax_lcg

−0.234 (−0.06) 41

Observations

16.01 (3.40) −6.109 (−0.55)

10.20∗ ∗ (2.53) 12.09∗ ∗ ∗ (3.23) 41

Tax_spread Constant

(4) ∗∗∗

−1.863 (−0.63) 41

10.06∗ ∗ (2.51) 10.93∗ ∗ ∗ (2.95) 41

Panel C: Different Tax Regimes Tax Regime

Low Dividend

2

3

4

High Dividend

High—Low

1963–1981

−2.031 (−3.43) −0.676 (−1.65) −1.393 (−1.89)

−0.062 (−0.187) 0.278 (0.43) −1.08 (−2.16)

0.312 (0.88) 0.435 (0.65) −0.649 (−1.34)

1.292 (−2.80) 0.458 (0.73) 1.58 (2.09)

1.603 (2.19) 1.04 (1.44) 4.248 (3.04)

3.634∗ ∗ ∗ (3.02) 1.715∗ ∗ (1.99) 5.640∗ ∗ ∗ (2.88)

1982–2002 2003–2014

indicate an insignificant but negative relation between market illiquidity and reaching for dividends, which does not support the hypothesis of transaction costs. Turning to the effect of taxes, we examine how the strength of reaching for dividends varies with tax rates. The first test uses variation in dividend and capital gains tax rates as continuous variables; the second test exploits two natural experiments in the sample period: the Economic Recovery Tax Act of 1981 and 2003 dividend tax reform. In Panel B of Table 6, we regress the difference in rolling three-year dollar duration estimates between high and low dividend stocks based on dividend yield (Columns 1 and 2) and dividend payout ratio (Columns 3 and 4) on average dividend tax rates and average capital gains tax rates, or their proportional difference T axspread = (1 − T axlcg )/(1 − T axd )9 during the past three 9

The higher the difference between dividend and capital gains tax rates, the larger the Taxspread .

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H. Jiang and Z. Sun / Journal of Monetary Economics xxx (xxxx) xxx Table 7 Impact of Interest Rate on Household Preferences for Dividends. This table studies how interest rates influence the preferences for dividends by retail investors with different age and income during the period 1991–1996. Along the dimension of age, we group investors into young (age below 45), middle (age between 45 and 65) and old (age above 65). For each month, we aggregate the holdings of investors within age group and calculate portfolio weight of individual stocks for each group. We regress the difference in a stock’s portfolio weight in basis points between old and young investors on the lagged dividend yield (DY), lagged interest rate, and the interaction between the two with controls. In column 1, Interest Rate is a continuous variable; In columns 2 and 3, Interest Rate is an indicator variable (Low Rate) that takes a value of 1 if interest rate falls below the median and 20th percentile over the sample period, respectively. We control for the natural log of market cap, log of the book-to-market ratio, average daily turnover in percentage and average daily idiosyncratic volatility (IV) during the past year, average daily excess return over the past month t − 1, from t − 6 to t − 2, t − 12 to t − 7, and the market beta of the stock computed using daily data in the past year. In columns 4 to 6, the dependent variable is the difference in portfolio weights between low income group (i.e. annual income below $40K) and high income group (above $75K). The standard errors are clustered on the stock level. ∗ ∗ ∗ stands for statistical significance at the 1% level; ∗ ∗ 5%; and ∗ 10%. Old–young (1) Interest Rate × DY

−1.538∗ ∗ (−2.33)

Low Rate × DY DY Interest Rate (Low Rate) Log(MarketCap) Log(BM) Beta Excret(t-1) Excret(t-6, t-2) Excret(t-12, t-7) IV Turnover Interest Rate × Beta (Low Rate × Beta) Intercept Observations Adj R2

12.332∗ ∗ (2.27) 0.001 (0.01) 0.117 (0.23) 0.914∗ ∗ (2.16) 0.193 (0.10) 28.518∗ ∗ ∗ (3.94) 159.685∗ ∗ ∗ (3.82) 153.099∗ ∗ (2.00) −43.045 (−1.38) −5.052∗ ∗ (−2.42) −0.051 (−0.20) 1.226 (0.17) 122,549 1.19%

Low–High income (2)

2.999∗ ∗ ∗ (2.63) 0.25 0.59 0.0002 0.00 0.117 0.23 0.915∗ ∗ 2.15 −0.176 (0.27) 29.131∗ ∗ ∗ 4.05 162.914∗ ∗ ∗ 3.87 152.567∗ ∗ 1.99 −43.167 (1.38) −5.049∗ ∗ (2.42) 0.032 0.09 1.236 0.19 122,549 1.19%

(3)

5.981∗ ∗ (2.48) 0.418 0.82 −0.095 (0.44) 0.118 0.24 0.911∗ ∗ 2.13 −0.162 (0.26) 28.892∗ ∗ ∗ 4.01 161.244∗ ∗ ∗ 3.84 149.984∗ ∗ 1.99 −43.231 (1.38) −5.034∗ ∗ (2.42) −0.035 (0.10) 1.251 0.19 122,549 1.19%

(4) −0.915∗ (−1.75)

7.210∗ (1.69) 0.05 (0.42) 0.249 0.67 0.687∗ ∗ (2.16) −1.201 (−0.67) 5.976 (1.16) 18.32 (0.57) −13.677 (−0.22) −3.448 (−0.14) 0.087 (0.08) −0.006 (−0.03) −2.355 (−0.45) 122,549 0.44%

(5)

(6)

1.563∗ (1.70) 0.048 (0.15) −0.063 (−0.38) 0.249 (0.67) 0.690∗ ∗ (2.16) −1.234∗ ∗ ∗ (−2.87) 6.128 (1.21) 19.12 (0.59) −13.881 (−0.23) −3.453 (−0.14) 0.084 (0.08) −0.016 (−0.05) −1.977 (−0.41) 122,549 0.44%

3.623∗ (1.93) 0.126 (0.34) −0.048 (−0.28) 0.248 (0.67) 0.692∗ ∗ (2.15) −1.217∗ ∗ ∗ (−2.66) 6.057 (1.19) 18.43 (0.57) −14.254 (−0.24) −3.47 (−0.14) 0.081 (0.08) −0.093 (−0.34) −1.992 (−0.41) 122,549 0.44%

years, available from Sialm (2009). It shows a positive coefficient for the dividend tax rate, but a coefficient statistically indistinguishable from zero for the capital gains tax rate. This result does not support the idea that lower dividend taxes increase the attraction of dividends relative to capital gains, which implies a negative coefficient. The regression on Taxspread generates a similar result. The Economic Recovery Tax Act of 1981 aimed to encourage economic growth through reductions in individual income tax rates. According to Sialm (2009), although tax rates dropped universally as a result of the act, the average marginal tax rate on dividend income drops by a larger percentage than the long term capital gain yield (14% versus 10%); the 2003 dividend tax reform introduced favorable tax treatment of individual dividend income, with the average marginal tax rate on qualified dividend income dropping by over 50%. The resulting declines in effective tax rates for dividends relative to capital gains may increase investor preference for high dividend stocks, strengthening the effect of reaching for dividends. Using the two tax reforms as the starting point of the regime shifts, we estimate the dollar duration for high and low dividend stocks during three sub-periods: 1963–1981, 1982–20 02, and 20 03–2014. The results in Panel C of Table 6 report mixed evidence. Specifically, the average difference in dollar duration between high and low dividend stocks decreased following the Economic Recovery Tax Act, but increased after the 2003 dividend tax reform. Given that the changes in relative tax rates for dividends against capital gains have the same direction,10 this result suggests that the tax effect is unlikely to be the main driver of our findings. 10 Based on the data provided by Sialm (2009), the difference in the average marginal tax rates between dividends and capital gains is 19.8%, 5.4% and −1.7% during 1963–1981, 1982–2002, and 2003–2006, respectively.

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15

Table 8 Impact of Market Returns on Household Preferences for Dividends. Panel A of this table studies how stock market returns influence the preferences for dividends by retail investors with different age and income during the period 1991–1996. Along the dimension of age, we group investors into young (age below 45), middle (age between 45 and 65) and old (age above 65). For each month, we aggregate the holdings of investors within age group and calculate portfolio weight of individual stocks for each group. We regress the difference in a stock’s portfolio weight in basis points between old and young investors on the lagged dividend yield (DY), lagged interest rate, and the interaction between the two with controls. In column 1, Market Return is a continuous variable; In columns 2 and 3, Market Return is an indicator variable (Low Return) that takes a value of 1 if market return falls below the median and 20th percentile over the sample period, respectively. We control for the natural log of market cap, log of the book-to-market ratio, average daily turnover in percentage and average daily idiosyncratic volatility (IV) during the past year, average daily excess return over the past month t − 1, from t − 6 to t − 2, t − 12 to t − 7, and the market beta of the stock computed using daily data in the past year. In columns 4 to 6, the dependent variable is the difference in portfolio weights between low income group (i.e. annual income below $40K) and high income group (above $75K). The standard errors are clustered on the stock level. ∗ ∗ ∗ stands for statistical significance at the 1% level; ∗ ∗ 5%; and ∗ 10%. Impact of Market Returns on Investor Preferences for Dividends (Continued) Panel B reports how stock market returns influence the preferences for dividends by income funds from 1980 to 2014. In each quarter, we sort stocks into quintile portfolio based on its dividend-price ratio (D/P) at the beginning of year. We calculate the weights of each portfolio in the income fund portfolio in excess of those in the market portfolio. We report the time-series average excess weights during different market conditions. Panel A: Individual investors Old-young (1) Market Return × DY

Market Return (Low Return) Log(MarketCap) Log(BM) Beta Excret(t-1) Excret(t-6, t-2) Excret(t-12, t-7) IV Turnover Market Return × Beta (Low Return × Beta) Intercept Observations Adj R2

(3)

−1.247 (−0.78)

Low Return × DY DY

Low–High income (2)

0.61 (0.97) 0.419 (0.29) 0.11 (0.22) 0.916∗ ∗ (2.15) −0.16 (−0.26) 27.478∗ ∗ ∗ (4.04) 160.417∗ ∗ ∗ −3.71 145.129∗ (1.89) −43.749 (−1.39) −5.026∗ ∗ (−2.42) −0.398 (−0.14) 1.375 (0.21) 120,938 1.18%

(4)

(5)

(6)

−0.301 (−1.35) 0.336 (0.67) 0.079 (1.19) 0.248 (0.67) 0.694∗ ∗ (2.16) −1.224∗ ∗ (−2.49) 4.834 (1.02) 16.073 −0.48 −16.236 (−0.27) −3.318 (−0.14) 0.07 (0.07) −0.057 (−0.41) −1.995 (−0.41) 120,938 0.44%

−1.785 (−1.07) −0.15 (−1.01) 0.676 (0.99) −0.026 (−0.30) 0.11 (0.22) 0.916∗ ∗ (2.15) −0.21 (−0.33) 27.490∗ ∗ ∗ (4.01) 160.860∗ ∗ ∗ −3.7 144.947∗ (1.89) −43.791 (−1.40) −5.026∗ ∗ (−2.42) 0.091 (0.55) 1.398 (0.22) 120,938 1.18%

−0.401 (−1.30) 0.721 (1.04) 0.068 (0.72) 0.11 (0.22) 0.916∗ ∗ (2.16) −0.143 (−0.23) 27.451∗ ∗ ∗ (4.02) 160.062∗ ∗ ∗ −3.71 145.196∗ (1.90) −43.681 (−1.39) −5.028∗ ∗ (−2.42) −0.119 (−0.66) 1.365 (0.21) 120,938 1.18%

0.27 (0.58) 0.232 (0.30) 0.248 (0.67) 0.695∗ ∗ (2.16) −1.229∗ ∗ (−2.55) 4.82 (1.01) 16.069 −0.48 −16.54 (−0.27) −3.31 (−0.13) 0.068 (0.07) −0.332 (−0.21) −1.982 (−0.41) 120,938 0.44%

−0.153 (−0.91) 0.329 (0.62) −0.049 (−0.91) 0.248 (0.67) 0.694∗ ∗ (2.16) −1.273∗ ∗ ∗ (−2.60) 4.795 (1.01) 16.289 −0.49 −16.934 (−0.28) −3.347 (−0.14) 0.068 (0.07) 0.079 (0.86) −1.95 (−0.40) 120,938 0.44%

Panel B: Income Funds Market Returns

Low Dividends 2 3 4 High Dividends

Low

2

3

4

High

High–Low

−0.09 (10.62) −0.038 (−5.54) 0.024 (3.63) 0.07 (15.50) 0.033 (5.04)

−0.079 (−10.67) −0.031 (−5.54) 0.016 (2.18) 0.057 (11.13) 0.038 (3.41)

−0.084 (−12.94) −0.036 (−6.18) 0.011 (1.71) 0.074 (14.20) 0.037 (4.90)

−0.087 (−15.21) −0.042 (−9.05) 0.014 (2.33) 0.077 (17.88) 0.038 (5.99)

−0.073 (−9.18) −0.024 (−4.24) 0.016 (2.54) 0.064 (14.47) 0.018 (2.23)

0.017 (1.42) 0.014 (1.52) −0.008 (−0.89) −0.006 (−0.99) −0.015 (−1.49)

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5.2. Behavioral factors Advances in behavior finance provide another promising avenue to understand investor preference for dividends. For instance, Thaler and Shefrin (1981) propose a theory of self-control, which is based on the idea that individuals faced with conflicting goals desire to employ devices for better self-control. This theory can explain a variety of self-imposed rules by individuals, such as “jogging at least two miles a day,” and “saving at least two percent of every paycheck for children’s college education, and never withdraw from this fund.” Shefrin and Statman (1984) apply this theory to explain the rule that “portfolio capital is not to be consumed, only dividends,” which in turn explains why investors may prefer cash dividends. Their study also applies the prospect theory in this context, and argues that mental accounting and regret avoidance can lead investors to prefer cash dividends as the source of consumption to capital gains. Since both the theory of self-control and prospect theory emphasize the importance of consumption needs and lead often to observationally equivalent predictions, we do not distinguish between the two, but refer to them broadly as consumption-oriented behavioral factors. In this subsection, we test for two implications of the consumption-oriented behavioral hypothesis: the preference for stocks with high dividends is positively correlated with age, but negatively correlated with income (human wealth). To test for these implications, we use the data from a large discount brokerage house (Barber and Odean, 20 0 0). During the period from 1991 to 1996, we group investors based on their age into young (age below 45), middle (age between 45 and 65) and old (age above 65), and calculate the portfolio weight of individual stocks for each age group. We then calculate the difference in portfolio weights between old and young investors and regress it on the dividend yield of the stock, interest rate, and their interaction term, with controls for stock characteristics and the interaction between stock beta and interest rate. Columns 1 to 3 of Table 7 summarize the results. We find that older investors on average invest more in higher dividend stocks, consistent with the existence of dividend clienteles (Graham and Kumar, 2006). More importantly, the difference in preferences for high dividend stocks between old and young investors varies with the level of interest rates, with the gap widening when interest rates are low. Along the income dimension, we sort investors into low income (annual income below $40K) and high income (that above $75K) groups, and perform a similar exercise. Columns 4 to 6 of Table 7 show that relative to the high-income investors, low-income investors invest more in high dividend stocks when interest rates are low. Overall, our results are consistent with the prediction of consumption-oriented behavioral factors. There is another hypothesis, which states that investors may simply view dividends as free money, thereby suffering from the free dividend fallacy (Hartzmark and Solomon, 2018). This hypothesis predicts that the tendency of free dividend fallacy is stronger when the market return is low, during economic recessions, and when stock market uncertainty such as the VIX is high. Panel A of Table 8 presents the results testing the prediction on market returns using the same discount brokerage data. Similar to the spirit of Table 7, it examines whether the difference in preferences for high dividend stocks between old (low income) and young (high income) investors widens when stock market returns are low. Different from Table 7 showing the importance of interest rates, however, the results in Panel A show that the difference in preferences for high dividend stocks between old (low income) and young (high income) investors does not depend on market states, which provides no support to the free dividend fallacy hypothesis. In another test, we exploit a categorical variable that classifies investors into groups with high and low financial knowledge. The results, as reported in the Internet Appendix, show that the difference in preferences for high dividend stocks between investors with low and high financial knowledge does not depend on market states either. Hartzmark and Solomon (2018) find that a subset of mutual funds appear to be subject to the dividend fallacy bias. Panel B of Table 8 examines whether income funds show stronger preferences for high dividend stocks when stock market returns are low. The advantage of this test is the availability of mutual fund holdings over a longer sample period starting from 1980. The results indicate that income funds do not show stronger preferences for high dividend stocks when stock market return is low. This result is different from that in Panel A of Table 2, which shows that income funds tend to increase their holdings of high dividend stocks when interest rates are low. In the Internet Appendix, we present empirical tests based on economic recessions and aggregate stock market uncertainty such as VIX, which lead to a similar conclusion. In combination, these results suggest that the free dividend fallacy may not be crucial in driving the behavior of reaching for dividends. 6. Conclusions This study has uncovered a tight link between interest rates and stock prices through the mechanism of investors “reaching for dividends.” We find that when interest rates fall, households increase their asset allocations from bonds to stocks, and flows into income-oriented stock mutual funds increase, with higher dividend-yielding funds attracting more inflows. Responding to their incentives, income fund managers more aggressively over-weight high dividend stocks in a low-rate environment. The higher investor demand for high dividend stocks appears to impact their prices and returns: stocks with higher dividends tend to have longer dollar duration, experiencing greater price increases when interest rates decline; moreover, lower interest rates forecast lower excess returns on high dividend stocks. In our initial attempts to explore the microfoundations of investor preference for cash dividends, we find that consumption-oriented behavioral factors such as self-control are important. Please cite this article as: H. Jiang and Z. Sun, Reaching for dividends, Journal of Monetary Economics, https://doi.org/10. 1016/j.jmoneco.2019.08.003

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Our study brings new evidence and a new perspective to understand the roots of interest rate risk. The dominant paradigm to evaluate interest rate risk is to assess the composition of a firm’s assets and liabilities, centering on the structure of their future cash flow streams. While intuitively appealing and analytically elegant, this approach, as we have shown, is powerless to fully explain interest rate risk in securities markets. For a better understanding of interest rate risk and perhaps risk in general, empirically grounded institutional and psychological features that shape investor demand are indispensable, and may be essential. Declaration of Competing Interest None. Acknowledgment We are grateful to the editor, Urban Jermann, and an anonymous referee for valuable comments and suggestions. We thank Andrew Ang, Patrick Bolton, Qingqing Cao, Charlie Hadlock, Sam Hartzmark, Harrison Hong, Ralph Koijen, Pete Kyle, Lars Lochstoer, Deborah Lucas, Stefan Nagel, Sheridan Titman, Annette Vissing-Jørgensen, Haoxiang Zhu and participants in the Inquire UK Seminar, Intelligent Investor Symposium, LA Finance Day, Paul Woolley Center Annual Conference, Q Group Conference, and seminars held at the ANU, the Federal Reserve, SUNY Albany, UC Irvine, Washington State, and York University for helpful comments. We also thank Terrance Odean for providing trading data of individual investors. This paper was previously titled “Equity Duration: A Puzzle on High Dividend Stocks.” Supplementary material Supplementary material associated with this article can be found, in the online version, at doi:10.1016/j.jmoneco.2019. 08.003. References Anton, M., Polk, C., 2014. Connected stocks. J. Finance 69 (3), 1099–1127. Baele, L., Bekaert, G., Inghelbrecht, K., 2010. 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