Stephen Dover, CFA, Chief Market Strategist, Head of Franklin Templeton Institute
Economic and political dislocations, recession fears, high inflation and aggressive monetary policy tightening have roiled markets in 2022, producing some of the worst results for global investors since the early 1970s.
Notably, volatility in the bond market is unusually high relative to equities. And when traditionally “safe” fixed income assets are leading the capital markets downward, it leads to questions on how to navigate this environment.
Taking a deeper look at the underlying factors driving asset prices and market volatility, duration is an important concept to consider across asset classes.
Here’s how duration plays a part within fixed income as well as equity investing:
What is duration?
Simply defined, duration is the expected holding period of an asset. The longer the duration, the greater the risk (sensitivity to interest rate changes), and the higher the required compensation an investor ought to demand.
For example, duration is why:
- Bonds that mature further in the future typically offer higher yields than those with shorter maturities.
- Assets with payoffs that arrive much later (such as longer-maturity bonds or growth stocks) will have prices that are typically more sensitive to changes in interest rates and returns over risk-free assets.
Duration risk: Not just for fixed income
While most investors typically associate duration with fixed income, its relationship to stocks is also relevant. For instance, when investors pay high prices for growing companies that are unprofitable today, they are presuming those companies will eventually earn enough to justify higher valuations.
The conditions that favor long duration are often the same for growth stocks and bonds, particularly the presence of low or falling interest rates. In 2022, interest rates rose to combat high inflation, and markets responded accordingly. Unsurprisingly, longer-duration bonds and growth stocks have fared poorly.
Are defensive bonds safe from duration risks?
The silver lining is that after decades of declining interest rates, higher bond yields are showing improved income opportunities within fixed income markets. Prospects for higher income are emerging across different market segments, including corporate bonds, government bonds and floating-rate loans.
As monetary policy tightens and there is a higher probability of recession, credit risk should be scrutinized since it typically increases as corporate financing costs rise and the economy weakens. For example, while the bonds of “defensive” companies (e.g., consumer staples) may offer higher “quality” characteristics, there is an element of interest-rate risk due to their longer duration.
Data as of Oct. 11, 20221
Looking at the duration of equities is more important than ever
Naturally, dynamic rebalancing requires continuous assessment of market prospects, above all for Federal Reserve (Fed) policy, inflation and growth. To the extent that inflation may soon peak, and growth slows, extending duration (i.e., holding onto the asset longer than initially expected) makes sense, even more so if coupled with income derived from shorter duration notes and bonds. That combination may be preferable to taking credit risk.
Rising interest rates pose risks, as has clearly been on display in 2022. But they also pose opportunity via income and rebalancing. Duration in stocks and bonds will remain under pressure until fundamental and technical factors (i.e., both inflation and Fed policy risk, as well as risk-parity deleveraging) have run their course. Dynamic rebalancing can increase returns per unit of risk and deliver better income opportunities for investors.
Market volatility and uncertainty are likely to linger. Changing fundamentals warrant revisiting portfolios to ensure that allocations remain consistent with investors’ risk appetites and return expectations. Contact your Ameriprise financial advisor to discuss strategies that can help you navigate this environment.