Duration risk, as most investors know, is the risk associated with changes in interest rates. The longer the duration of the asset, the more affected it should be by changes in underlying rates. Duration risk is most often associated with fixed-rate bonds, but equities are also considered long-duration assets. Although opinions vary on how to properly calculate equity duration, a common approach is the inverse of the dividend yield. The dividend yield of the S&P 500 Index has hovered between 1.5% and 2.0% over the last few years, equating to a duration of between 50 and 67 years. This is an interesting factoid, but what does it have to do with anything?
Over the last few years, many in the industry, myself included, have discussed that equities were overvalued, justified by tightening yields and high price-to-earnings multiples. At the same time, others have used the equity risk premium (ERP), a comparison of equity and bond yields, as justification that US stocks, in particular, have actually been cheap. The story goes that stock investors are willing to accept a lower yield because the alternative—bonds—is also trading at a low yield.1
This explanation was recently used by Jerome Powell, Chairman of the Federal Reserve—“Admittedly (price-to-earnings multiples) are high…but that’s maybe not as relevant in a world where we think the 10-year Treasury is going to be lower than it’s been historically from a term perspective” (Cox, 2020)—and Professor Robert Shiller—“But with interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds” (Shiller, Black, and Jivraj, 2020).
A comparison of the current value of bonds versus stocks within the context of the equity risk premium, coupled with potential US Federal Reserve policy direction, leads us to conclude that risk assets, such as equities and corporate bonds, may be poised for additional positive returns in the future.