Is your equity portfolio sensitive to interest rates?

Is your equity portfolio sensitive to interest rates?

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The current environment should continue to favor low duration assets over high duration assets.

Determining whether an impact equity portfolio is interest rate sensitive depends critically on its thematic exposures. More importantly, the wide variety of themes and the breadth of their duration allow active portfolio managers to construct a well-balanced portfolio whose sensitivity to changes in interest rates is not too different from that of the general market. This is particularly important in the current environment of rising interest rates, high interest rate volatility and high inflation, which should continue to favor low duration assets over high duration assets.

Rising interest rates have a disastrous effect on the price of long-term bonds. We have seen the long dated Austrian bond (RAGB 2.1 09/20/2117) drop from a high of 235 to a low of 76.5 in just 18 months, as interest rates fell from -0.50% to 2.3%. This is an extreme example of how duration drives bond yields. In a world where every basis point is looked at twice, fixed income portfolio managers are very aware of the effect of duration, which they often actively manage.

In the world of equities, duration is not as common. The emphasis here is often (wrongly) on the magic concept of growth. But growth without profits makes no sense to the stock investor. Sooner or later things will go wrong…

However, it is possible to take the definition of duration and apply it to listed stocks. It is intuitive that the public shares of most companies behave like long-lived assets because they do not have a fixed maturity. To be convinced of this, it suffices to consider the P/E ratios in the range of 14 to 127 for the largest public companies, see table 1 for the P/E ratios of the 10 largest positions of the MSCI ACWI.

Table 1: Current Price/Earnings (2022/08/04) and Implied Stock Duration for the Top 10 MSCI ACWI Positions

Source: Bloomberg for the P/E ratios, own calculation for the implied duration of the shares.

Not surprisingly, information technology and healthcare are the sectors with the longest duration, as shown in Chart 1. The financials and real estate sectors have the shortest duration. The information technology sector contains many names whose current valuation implies high growth rates and profitability that will only appear in the distant future, which explains the long average duration of the sector.

In terms of regional differences, the average implied equity duration in North America is 21.6 years, two years longer than the 19.5 years in Europe and 3.5 years longer than the average duration of 18. 0 years in Japan. The average duration of 18.8 years in emerging markets falls between Japan and Europe.

With growing awareness of the long-term systemic risk of climate change and other sustainability risks, there is a growing trend to invest in companies whose cash flows come from managing these risks ( so-called sustainable or environmental themes). The usual arguments are that these companies have great prospects for future growth due to the rapid increase in demand. The risk, however, is that these companies are exposed to rising interest rate environments and thus introduce unexpected portfolio risks for the sustainable investor. To test for these risks, we compared the implied duration of stocks of some popular environmental impact themes with their broader sector or unsustainable alternatives.

Electricity production

Chart 2 zooms in on the implied median duration of stocks of companies belonging to the different types of energy production methods. When energy is produced from fossil fuels, the duration is generally short, with only 19 years for coal and 20.5 years for natural gas. Nuclear is between the two with an average duration of 19.6 years. It should be noted, however, the longer duration of solar power generation companies, with an average of 22.6 years. If a profile closer to natural gas is required, wind and hydro are viable alternatives with durations of 21.0 and 20.4 years. Electrical power distribution, however, has a significantly lower average life of just 17.6 years.

The shorter duration of fossil fuel companies, particularly coal-fired power generation, is not surprising given their currently high cash distributions to equity holders. Additionally, these distributions are expected to remain high for the foreseeable future as the economy transitions to cleaner energy. In the next stage of the transition, fossil fuel distributions will be replaced by their renewable alternatives, which is why renewables have a longer implied duration on average.

Industrial

The industrial sector has a high average duration of 20.2 years. Within this sector, business and professional services have the longest duration at 21.3 years. We highlight three segments of the industrial sector that are popular in environmental impact investing, namely battery manufacturing, wind turbine manufacturing, and waste management and remediation services. All of these segments have a longer duration than the average industrial company, which makes them more sensitive to changes in interest rates.

Overall, most of the high-impact sectors we have highlighted have above-average interest rate sensitivity. However, there are plenty of lower duration opportunities in high impact sectors related to recycling or manufacturing, in addition to the electricity distribution industry. Thus, the wide variety of themes and the breadth of their duration allow active portfolio managers to build a well-balanced portfolio whose sensitivity to interest rate changes is not too different from that of the general market.

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