Duration, which measures sensitivity to interest rate changes, can apply to any asset that generates cash flows.
When investors think duration, they typically think fixed income – but understanding duration for equities can be a useful tool to help investors contextualize a stock’s value as it relates to interest rates.
Duration, which measures sensitivity to interest rate changes, can apply to any asset that generates cash flows. Calculating duration for bonds is straightforward because there is a fixed maturity and a fixed coupon. Bonds with shorter maturities and larger coupons have lower duration. That’s because when interest rates change, the present value for payments in the near future will change less than for payments in the distant future.
With equities, however, there is no maturity endpoint and cash flows vary. Nevertheless, stocks generating cash flows currently have a shorter duration than stocks where cash flows are a distant aspiration.
Duration and dividends
Where we would expect tighter monetary conditions to apply the most pressure to price multiples is within speculative growth-oriented stocks. These companies generally have longer durations (a large portion of expected cash flows further out in the future), exposing shareholders to a higher degree of uncertainty and carrying greater interest rate risk. Recent years characterized by near-zero rates and quantitative easing have driven significant multiple-expansion for these stocks, but as global monetary regimes continue to normalize, they will likely face headwinds going forward.
Conversely, short-duration equities tend to be less sensitive to changes in the discount rate and thus, more durable in a rising rate environment. These companies are generating strong cash flows today, paying dividends today and engaging in share buy-backs programs. This point is key, as it runs counter to a traditionally held belief that all dividend paying stocks are “bond proxies”, who will suffer when rates rise.
While there is some merit in comparing income equities to bonds, not all dividend paying stocks are equal. The key is growing levels of free cash flow (and by extension dividends). Dividend payers who consistently grow their dividends will remain more attractive sources of yield than bond substitutes whose coupon is fixed, especially in inflationary environments like the one we’re in now.
Looking ahead
Eleven months into 2022 and much of what is discussed here is already observable in markets. As central banks across the globe have aggressively raised interest rates to tame inflation, we’ve seen a significant revaluation of long-duration equities. In contrast, shorter-duration equities have proven far more resilient to the heightened rate environment.
Global economic growth continues to be pressured by aggressive central banks, the conflict in Ukraine, supply chain kinks left over from the pandemic, and a stark shift in a decades-long trend of globalization. With discount rates rising and growth slowing, markets going forward will likely be more fundamentally driven, favouring short-duration, dividend paying companies with strong balance sheets and substantial present day cash flows. The current macro backdrop is a signal for investors to further emphasize these traits in their portfolios and to take a more defensive approach to their equity allocations.
John Tobin is portfolio manager, Global Equity Shareholder Yield strategies, at Epoch Investment Partners
The information included in this article is provided for informational purposes only and is not investment advice of any nature. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions.
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