almost 3 years ago • 4 mins
Investors’ attention has understandably been focused on rising bond yields recently, given their implications for interest rates and stock markets. But one under-discussed aspect of both stock and bond markets is duration.
Put simply, duration is a measure of an investment’s price’s sensitivity to changes in interest rates. With rates now perhaps looking likely to rise earlier than previously thought, such sensitivity may soon become an urgent question for investors – which is why I wanted to address it in today’s Insight.
Duration’s usually talked about in relation to bonds. For a perpetual bond (i.e. one with no maturity date), it’s calculated as the inverse of the bond’s yield: a perpetual bond with a 5% yield, for example, would have a duration of 20 – meaning that a 1 percentage point increase in yield from 5% to 6% will, all else equal, reduce the bond’s value by 20%.
But for bonds with a fixed maturity date (i.e. most of them), the time remaining until that date and the bond’s coupon level matter too. The longer to go until the bond’s repaid, or the smaller the size of its regular payments, the higher its duration will generally be. That’s hopefully intuitive: smaller sums upfront may mean a longer repayment period, and longer periods are inherently more exposed to the risk of interest rates changing.
Here’s how you can use that information: if you think central bank interest rates are going to go up, you can apply the increase you’re expecting to existing bonds’ yields in order to forecast what’ll happen to their prices. A higher duration, of course, means a bond’s price will theoretically fall further.
It’s a calculation you can apply to stocks too, though it’s rarely done. Since companies don’t have an expiry date, you can treat them as you would perpetual bonds. And while investing in stocks doesn’t guarantee you fixed future payouts, companies often do offer dividends that you can use to calculate a long-term yield equivalent instead. The table below explains how:
An easier way to calculate a stock’s duration is to do as you would with a perpetual bond and simply take the inverse of its present-day dividend yield. The collective dividend yield of the US S&P 500 index overall has been approximately 2% since 2010 – but right now it’s at 1.46%. That means that US stocks’ duration is currently about 35% above its recent historical average…
With this in mind, it’s perhaps less surprising that:
1️⃣ Investors worried about the prospect of forthcoming rate hikes in the US sent the country’s stocks down sharply earlier this month
2️⃣ The stocks investors have been buying have had a shorter duration: typically those in sectors where earnings (and therefore dividend) growth is cyclical. With economic recovery inbound, dividends here are likely to rise quickly in the near term – unlike with “growth” stocks like tech.
This latter point provides a timely reminder that stocks with low or non-existent dividends don’t just fail to provide you with income as an investor; their higher duration also means they pose a risk to your portfolio when interest rates are rising. The sorts of stocks that have enjoyed the highest price rises over the past year are exactly those which stand to lose the most when rising inflation is eventually met with higher US central bank rates.
Outside the US, meanwhile, duration analysis throws up a potential opportunity. While US stocks’ current dividend yield is 1.46%, non-US stocks are showing an average dividend yield of 2.81% at present compared to a long-term average of about 3.5%. That implies non-US stocks have a current duration “only” 25% above their historical average, and that local rate hikes – all else equal – should have a less extreme negative effect on their prices than for their American counterparts.
In summary, stocks with higher dividends have a lower duration – and that might be a characteristic you want in your portfolio right now. This holds true whether you’re worried yourself about the potential impact of interest rate rises on stocks – or whether you’re instead worried about other investors worrying about rate rises, which can have much the same negative effect as a rate hike.
If I’ve inspired you to spring into mitigating action, you might want to consider the BlackRock-owned iShares MSCI ACWI ex-U.S. exchange-traded fund (ETF), or else the Vanguard-owned FTSE All-World ex-US or Total International Stock ETFs – all of which track major stocks or stock markets outside the United States.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.