Is your equity impact portfolio sensitive to interest rates?

August 19, 2022

Is your equity impact portfolio sensitive to interest rates?

The fundamental price of any financial asset equals the discounted value of its future cash-flows. This means that, all other things staying equal, when interest rates are rising the fundamental value of an asset decreases.

Therefore, rising interest rates have a disastrous effect on the price of long-dated bonds. We have seen the Austrian long-dated bond (RAGB 2.1 09/20/2117) move from a high of 235 to a low of 76.5 over a period of just 18 months while interest rates moved from -0.50% to 2.3%. This is an extreme example of how duration drives bond returns. In a world where every basis point is examined twice, fixed income portfolio managers are awfully aware of the effect of duration, which they often manage actively.

In the equity world, duration is not as commonplace. Here the focus often (mistakenly) lies on the magical concept of growth. We remind the reader that growth without profits (i.e., cash-flows) is meaningless for the equity investor. Sooner or later, matters will turn for the worse.

However, it is possible to take the definition of duration (weighted average maturity of discounted future cash flows) and apply it to listed equities . It is intuitive that most companies’ public equity behaves as long-duration assets as they don’t have fixed maturities. To see this, simply consider the P/E ratios (number of years of earnings that are required to recover the current price) in the range of 14 to 127 for the largest public companies, see Table 1 for the P/E ratios of the 10 largest holdings in MSCI ACWI.

Unsurprisingly, Information Technology and Health Care are the sectors with the longest duration, as shown in Figure 1. Financials and Real Estate have the shortest duration. The IT sector contains many names where the current valuation implies high growth rates and profitability arising only far in the future, leading to the average long duration of the sector.

In terms of regional differences, the average implied equity duration in North America is 21.6, two years longer than the 19.5 in Europe and 3.5 year longer than the average duration of 18.0 in Japan. The average duration of 18.8 year in Emerging Markets lies between Japan and Europe.

Given the growing realisation of long run systemic risk of climate change and other sustainability related risks there has been a growing trend to invest in businesses whose cash flows come from addressing these risks (so called sustainable and or environmental themes). The usual arguments are that such business have large future growth prospects due to fast increasing demand. The risk however is that these businesses may be exposed in rising interest rate environments and so introduce unexpected portfolio risks for the sustainable investor. To test these risks, we compared the implied equity duration of some popular environmental impact themes with their broader sector or unsustainable alternatives.

Power generation

Figure 2 zooms in on the median implied equity duration of companies within different types of power generation methods. When energy is generated from fossils, the duration is generally on the short side with only 19 years for coal power and 20.5 years for natural gas. Nuclear lies in between with an average duration of 19.6. However, special notice needs to be given to the higher duration of solar power generation companies at a mean of 22.6 years. If a profile closer to natural gas is required, wind and hydroelectric power generation are viable alternatives with duration values of 21.0 and 20.4 years. Electric Power distribution, however, has a significantly lower average duration of only 17.6 year.

The shorter duration of fossil fuel companies, in particular coal power generation, is not surprising given their currently high cash distributions to equity holders. Moreover, these distributions are expected to remain high in the near future while the economy is transitioning to cleaner energy. In the next stage of the transition, fossil fuel distributions are replaced by their renewable alternatives, explaining why renewables on average have a larger implied duration.

Industrials

The industrials sector has a medium-high average duration of 20.2 years. Within industrials, Commercial and Professional Services have the longest duration at 21.3 years. We highlight three segments within Industrials that are popular in environmental impact investing, namely battery manufacturing, wind turbine manufacturing and waste management and remediation services. These all have a longer duration than the average industrial company, making them more sensitive to changes in interest rates.

Conclusion

Overall, most of the high impact sectors that we highlighted have a higher-than-average sensitivity to interest rates. However, there are plenty of lower duration opportunities within impactful sectors related to recycling or within manufacturing in addition to the power distribution industry that we highlighted earlier. Thus, determining whether your impact equity portfolio is sensitive to interest rates crucially depends on its thematic exposures. Most importantly, the wide variety of themes and their range in their duration makes it possible for active portfolio managers to construct a well-balanced portfolio whose sensitivity to interest rate changes is not too different from the general market’s sensitivity. This is particularly important in the current environment of rising interest rates, high interest rate volatility, and high inflation, which should continue to favour low duration assets over high duration ones.

Source: Bloomberg for P/E ratios, own calculation for implied equity duration.
Interest rates as given by the Austrian 10-year government bond.
We take the definition in Dechow, Sloan and Soliman, 2004. Implied equity duration: A new measure of equity risk. Review of Accounting Studies, 9(2), 197-228.
The regions correspond to MSCI North America, MSCI Europe, MSCI Japan and MSCI Emerging Markets, durations by own calculation.

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