Duration risk doesn’t stop at bonds, and it’s something equity investors understand better


Martin Pelletier: Duration risk applies a lot to other assets like stocks

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One of the biggest factors that can impact your portfolio is duration exposure, which few or no investors realize or perhaps even measure and track, which could mean that excessive risk is taken unknowingly.

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Duration is a measure of an investment’s sensitivity to interest rates: the longer the duration, the more it will react to changes in interest rates. For example, the price of a 10-year bond will react more to a change in interest rates than a five-year bond. Put simply, if rates were to rise by 1%, a bond with an average duration of five years would likely lose about 5% of its value versus a decline of 10% for a bond with an average duration of 10 years.

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However, what many don’t realize is that duration risk doesn’t stop with bonds. This also applies very well to other assets such as stocks.

For example, companies in high-growth sectors like technology depend on extremely low interest rates to finance their growth and, therefore, are extremely sensitive to rate changes. This is because many of these companies spend way more than their cash flow and higher rates mean higher costs and limits on how much they can raise and spend.

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Quantitative easing (QE) and cheap capital have allowed these companies to deploy a lead-at-a-loss model in which they provide their products and services at or below cost in order to grow their ecosystem and then trade there. deploy premium services.

The United States has been a global market leader because its QE efforts have provided jet fuel to these segments of the economy, driving higher growth and returns. As a result, the top companies dominating the S&P 500 are Apple Inc., Microsoft Corp., Amazon.com Inc., Alphabet Inc., and Tesla Inc.

This has also benefited bond investors, as interest rates have trended lower for most of the past 35 years, especially since the implementation of QE following the Great Financial Crisis of 2008.

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That said, there is something happening that could put an end to all of this: inflation.

Central bankers want to keep the rate party low for as long as possible, so they told us until recently that inflation was transitory. Then, the Russian invasion of Ukraine puts further pressure on energy and agricultural supplies, sending inflation rates even higher. Wage growth is also expected to continue to climb, as employees have plenty of power in a tight labor market to demand more money to offset the rapidly rising cost of living.

For an important perspective on where rates should be, Gina Martin Adams, chief equity strategist at Bloomberg Intelligence, said Taylor’s rule implies that the policy rate should be a whopping six percent even taking into account a slower economic growth and inflation over the next year. This compares to the recently raised federal funds rate of 0.5% – think about that difference for a second.

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As a result, market segments that have benefited from their duration exposure over the past decade are now in a correction phase. For example, 20-year US Treasuries are down 15% from their December 2021 highs and, closer to home, the FTSE Canada All Government Bond Index is down 7.5% to now this year.

In equity markets, the long-duration segments are also being hit hard: the Nasdaq is down nearly 20% from its November 2021 highs, while the tech-heavy S&P 500 is down around 10% from its January highs.

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However, many pundits are still recommending investors buy this dip, adding to their duration exposure, simply betting that central bankers such as the Fed will continue to hold the tap and moderate their upward pace. Their logic is that inflation will dissipate, even to the point of deflationary pressures, through technological innovations such as automation.

Something to remember though: the world is a very different place to what it was before COVID-19, so before you hit that buy button, at least be aware of the exposure time already present in your wallet and make sure it matches both your ability and your will. to absorb risks before adding to them.

Martin Pelletier, CFA, is a Senior Portfolio Manager at Wellington-Altus Private Counsel Inc, trading as TriVest Wealth Counsel, a private client and institutional investment firm specializing in risk-managed discretionary portfolios, audit /investment monitoring and advanced tax, estate and wealth planning.


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