By: Phil Kernen
Asset duration was a powerful force for investors worldwide in an era of easy monetary policy. Now that rates are rising and policy is tightening, investors are relearning the risks that accompany duration. What is asset duration? And how can investors better understand and consider it responsibly in their decision-making process?
Most investors know that bonds and interest rates have an inverse relationship – when rates decline, bond prices increase, and vice versa. Duration is a measure of sensitivity to those rate changes, telling us the degree of price changes we can expect for any shift in interest rates. Technically, duration calculates how long an investor will take to recover his purchase price through cash flows from the bond. Since the principal repayment is usually the most significant part of cash flows, longer maturities typically come with a higher duration and more interest rate risk.
Investors have several ways to calculate asset duration, but specificity is less important than understanding broad parameters. You can calculate the duration for a bond here with five pieces of data: years to maturity, current yield, face value, coupon rate, and frequency of payments.
Duration for a bond can change over time due to changes in market rates or a decline in the number of years to maturity. Duration is dynamic and affects a bond index as bonds move in and out of the index universe. Consider two examples: the Aggregate Bond Index and the Intermediate Aggregate Bond Index, differentiated only by a shorter set of maturity parameters for the latter. The Aggregate Bond index carries a higher duration and is more sensitive to interest rate changes than the Intermediate Aggregate Bond index. That additional sensitivity explains why the Aggregate Bond index has lost more value in 2022 following rapid interest rate increases.
Duration is like leverage, or borrowing money. When times are good, consumers borrow more to buy assets hoping they will increase in value. Businesses often borrow to fund business ventures in the hopes that earnings will be more than enough to cover payments for principal and interest. When times turn sour, the assets don’t appreciate, or product sales and consumer activity decline, that leverage is a source of investment and business loss.
For investors who built bond portfolios like the indexes above, more duration has been helpful in the low and declining rates over the last decade. Now that rates are rising, those same bond portfolios are getting whipsawed in ways they didn’t expect. Imagine the surprise to learn your portfolio ballast, your safe bonds, is down nearly 15%. At the same time, stocks are down more than 20%.
Duration is not limited to bonds – it also applies to stocks, though less precisely. Stocks don’t have a defined maturity or coupon rate. Instead, assumptions and future expectations drive stock duration, often calculated using dividends and an assumed selling date. Investors need to make assumptions about the timing and number of dividends and ultimate sales price. Holding period assumptions are critical.
Stock durations can range widely too. Investors who pay for mature, profitable value stocks expect earnings to support the price relatively soon. Duration for value stocks is lower compared to other stocks. When investors pay high prices for growing companies that may be unprofitable today, they are expecting those companies to earn enough to support higher valuations.
Because those growth company cash flows are expected well into the future, sometimes very far, the duration for growth stocks is higher. If those stocks sell for very high price / earnings (PE) ratios, the duration may be higher still. Sometimes, the assumed holding period to support such prices could only be forever. Think of pandemic-era favorites like electric truck maker Rivian, plant-based burger maker Beyond Meat, and exercise equipment maker Peloton. Their incredibly high PE ratios meant a very high duration, and their prices plummeted when interest rates started rising.
Every asset value is subject to interest rates; duration is always part of the assets we hold and, thus, the portfolios we build. As investors transition to an era where interest rates are no longer artificially suppressed by central banks worldwide, understanding duration and how it can affect your portfolio will serve you well.