Aha! Interest Rates Do Matter

Aha! Interest rates do matter.

Investors have been spoiled by the trend in falling long-term interest rates over the past 40 years, and have only occasionally had to worry about equity strategies for a rising rate environment. The economic backdrop may now be changing, but investors seem hesitant to alter their investment strategies.

During the early-1990s, we were among the first researchers to investigate “equity duration”, or equities’ sensitivity to changes in interest rates. Long-term interest rates have always been a critical factor for valuation, but equity duration was a more advanced concept in that it not only looked at interest rates, but also the relationship between earnings, interest rates, and the interaction between the two.

Long-term interest rates have started to increase as the Fed extricates itself from cornering the long-term Treasury market. Yet, up to very recently, investors have been relatively hesitant to sell the longest-duration equities. Technology, venture capital, cryptocurrencies, innovation, and disruption are all long-duration strategies that performed very well as long-term interest rates fell. It seems unrealistic to expect the biggest beneficiaries of falling interest rates to outperform as interest rates rise.

What is duration?

Duration is a measure of price’s sensitivity to interest rates measured in years. For example, a 30-year zero-coupon bond has a duration of 30 years because all of the return is received in year 30 when principal is received. A 30-year coupon paying bond would have a shorter duration because coupon payments would be received during each year until the principal is returned in year 30. Currently, the 30-year coupon paying government note has a duration of about 23 years versus the 30-year duration of the zero.

Shorter duration bonds should have less interest-rate sensitivity than would longer-duration bonds. All things being equal, a bond with a 30-year duration should move up or down 30% for every one-percentage point move in interest rates. A 30-year zero coupon bond would likely outperform the coupon-paying equivalent during periods of falling interest rates, and vice versa.