Low Duration Stocks

Bond investors are familiar with a concept known as duration. It relates to the timing of expected cash flows and to how much price and yield move in relation to each other.

Think of price and yield as two ends of a teeter totter. When the yield of a bond rises, the price falls, and when yield falls, the price rises.

A low duration bond is one where the cash flows – coupon (interest) payments and return of principal – occur in the near future, and a high duration bond is when they are more distant. With a low duration bond, yield sits on the long end of the teeter totter and price on the short. With a long duration bond, yield sits on the short end and price on the long.

That is, the longer the duration of a bond, the more price changes with any given change in yield.

This is not so much a matter of cause and effect, but of math. Each end of the teeter totter is rigidly connected to the other.

Stocks have duration too. A stock that pays substantial dividends in relation to its price begins returning cash to its owner in the near future and is a relatively low duration stock. A stock that pays little or no dividends but is owned on the premise of future growth is a relatively high duration stock.

The subject of duration was raised in a recent article by Bloomberg’s Simon White appearing on ZeroHedge. White makes the case that high duration stocks are poised to underperform:

Stock Duration More Vulnerable As Inflation Risks Bristle

Financology readers who may be interested in a relatively low duration stock portfolio need not start from scratch. It happens that the Financology Model Income Portfolios emphasize low duration stocks. They’re light on the long duration, low yield, richly valued growth stocks that were in vogue last year, and rich in dividend paying stocks, quality and value. Sector-wise they tend to be light on tech and heavy on energy, just as White suggests.

I wouldn’t necessarily count on White’s prediction that low duration stocks could be negatively correlated with bonds. If long duration bonds outperform short duration bonds, long duration stocks could outperform short duration stocks as well. But the inverted yield curve suggests that short yields have more downside potential than long, meaning that they have more return potential in relation to their duration than the usual price-yield relationship would dictate.

As explained in the associated discussion, these income portfolios weren’t so much designed for a particular market environment as tailored to meet certain portfolio goals. But if White is right, they also happen to be especially timely in this market environment.