The rapid rise in interest rates triggered by stubborn inflationary pressures has been reshaping US equity market leadership relative to the past decade. Higher interest rates have created many challenges for investors including downward pressure on equity valuations.
Investors often value equities by calculating the present value of expected future cash flows and using an appropriate rate of return (discount rate) that adequately compensates for the risk of an investment. All else being equal, higher interest rates produce lower valuations. However, when it comes to valuing stocks and understanding embedded valuation risk, not all equities are created equal.
Businesses whose valuations are supported by lofty growth expectations farther out into the future are disproportionately negatively impacted by higher interest rates, relative to businesses with high levels of current cash flow growing at a more modest rate. Businesses which exhibit longer dated cash flows are said to have higher equity duration.
WHAT IS DURATION?
The duration of an asset is defined as the average time that it takes for the asset’s future cash flows to be received and ‘repay’ the cost of the investment. Duration also measures an asset’s price sensitivity to changes in interest rates. As such, duration is commonly used to measure interest rate risk in the fixed income world.
As interest rates rise, bond prices typically decline to account for the lower present value of expected future cash flows. Bonds with higher duration experience greater price declines because a greater proportion of their cash flows originate farther out into the future (i.e. longer maturity dates). However, the concept of duration can also be applied to stocks.
Equity duration measures the sensitivity of a stock’s price in relation to changes in interest rates. When interest rates rise, the present value of expected future cash flows to shareholders decreases, leading to a decline in stock prices. Conversely, when interest rates fall, the present value of those same future cash flows will generally increase.
WHY DOES EQUITY DURATION MATTER?
Equity duration matters because changes in interest rate will impact equity values, and this impact can be amplified by the timing and magnitude of expected future cash flows. Stocks with similar underlying values may perform very differently based on their respective duration values.
Consider the case of two individual stocks which exhibit comparable underlying values. Stock A is our high duration (HD) example with the bulk of its future cash flows expected to materialize in the latter half of our 10-year time horizon.
Today, Stock A’s business does not generate positive cash flow, but its valuation is underpinned by significant growth expectations in years 5 through 10. As such, these ‘long dated’ cash flows make up the majority of its underlying value. Accordingly, Stock A has a relatively high equity duration value of 17.5.
Stock B is our low duration (LD) example. Stock B’s business currently generates positive cash flow and exhibits a lower growth profile over the same 10-year time horizon. Although its estimated underlying value is equivalent to that of Stock A, it is much less dependent on the promise of future growth to arrive at the same value. It has an equity duration value of 10.1 – notably lower than Stock A.
Stock A exhibits the fundamental characteristics of a traditional ‘growth stock’ while Stock B would generally fit into the ‘value stock’ category. Usually, high duration equities are disproportionately found within the growth category while low duration equities are synonymous with value stocks.
Equity duration comes into play when we consider changes in interest rate levels. All else being equal, a 0.5% increase in interest rates decreases the value of high duration stocks much more than low duration stocks. Conversely, a decrease in interest rates disproportionately benefits the value of high duration stocks. For our 2-stock example, if we increase interest rates in increments of 50 basis points to 8.5% and 9% respectively, the corresponding declines in underlying value are greater for our high duration stock example vs. our low duration example. This relationship also holds true if we decrease interest rates with our high duration example yielding proportionately greater increases in underlying value relative to our low duration example.
Recent US equity market performance validates these findings with value stocks outperforming from mid-2021 through 2022 as the 10-year Treasury yield increased from 1.3% to over 4%. More recently, the 10-year Treasury yield has retreated toward the 3.5% level allowing growth stocks to outperform again on a year-to-date basis.
Source: Scotiabank GBM Portfolio Strategy, Bloomberg.
THE TIES BETWEEN EQUITY DURATION AND RISK MANAGEMENT
Equity duration is an important risk management tool to help understand interest rate risk for individual stocks and within investment portfolios. Underlying value estimates which incorporate optimistic, long-dated growth forecasts, may not provide investors with adequate compensation (expected return) for a given level of risk – particularly in a rising interest rate backdrop. As such, equity duration provides investors with a unique viewpoint into potential valuation risks for a given interest rate environment, particularly when value is expected to accrue in the latter part of the investment time horizon.