Martin Pelletier: Duration risk very much applies to other assets such as stocks
Stock market information on the floor of the New York Stock Exchange. Photo by Michael Nagle/Bloomberg files One of the most important factors that can impact your portfolio is duration exposure, something few if any investors realize or perhaps even measure and track, which could mean excessive risks are unknowingly being taken.
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Duration is a measure of an investment’s sensitivity to interest rates: the greater the duration, the greater it will react to changes in interest rates. For example, a 10-year bond price will react more to a change in interest rates than a five-year bond. Simplistically put, if rates were to rise one per cent, a bond with a five-year average duration would likely lose approximately five per cent of its value versus a 10 per cent drop in a bond with a 10-year average duration.
However, what many don’t realize is that duration risk doesn’t just stop with bonds. It also very much applies to other assets such as stocks.
For example, companies in high-growth sectors like technology depend on ultra-low interest rates to fund their growth and, therefore, are extremely sensitive to changes in rates. This is because many of these companies are spending well in excess of their cash flow and higher rates mean greater costs and limitations 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 loss-lead model whereby they provide their products and services at or below cost in order to build out their ecosystem and then deploy premium services into it.
The United States has been a market leader globally because its QE efforts provided jet fuel to these segments of the economy, leading to superior growth and returns. As a result, the top companies that dominate the S&P 500 are Apple Inc., Microsoft Corp., Amazon.com Inc., Alphabet Inc. and Tesla Inc.
This, too, has benefited bond investors, since interest rates have been in a downward trend for the greater part of the past 35 years, more so since QE was implemented following the 2008 Great Financial Crisis.
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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 low-rate party going for as long as possible, so they’ve been telling us until recently that inflation is transitory. Then the Russian invasion of Ukraine puts further pressure on energy and agriculture supplies, sending inflation rates even higher. Wage growth should also continue to climb higher as employees have a lot of power in a tight labour market to demand more money to offset the rapidly rising cost of living.
For some important perspective on where rates should be, Gina Martin Adams, chief equity strategist at Bloomberg Intelligence, said the Taylor Rule implies the policy rate should be a whopping six per cent even when factoring a slowdown in both economic growth and inflation over the next year. This compares to the recently increased Fed funds rate to 0.5 per cent — think about that difference for a second.
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More On This Topic Three risks that could cause you financial harm in the near future The U.S. poses a serious threat of enticing Canada’s skilled workers to move south Investors want both sky-high returns and the comfort of safety As a result, those segments of the market that benefited from their duration exposure over the past decade are now in a correction. For example, 20-year U.S. Treasuries are down 15 per cent from their December 2021 highs, and, closer to home, the FTSE Canada All Government Bond Index is off 7.5 per cent so far this year.
In equity markets, long-duration segments are also getting hit hard: the Nasdaq is down nearly 20 per cent from its November 2021 highs, while the tech-heavy S&P 500 is down approximately 10 per cent from its January highs.
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Article content However, so many pundits are still recommending investors buy this dip, thereby adding to their duration exposure, simply on a bet that central bankers such as the Fed will continue to keep the taps flowing and moderate their pace of hikes. 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 than it was pre-COVID-19, so before hitting that buy button, at least be aware of the duration exposure already within your portfolio and make sure it matches both your ability and willingness to absorb risks before adding more.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.
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