Duration might be an abstract concept for most investors, but it became very real earlier this month when Silicon Valley Bank, part of SVB Financial, collapsed, becoming the second-biggest bank failure in U.S. history.
There were a number of reasons for the bank's collapse. Its depositor base was highly concentrated in tech companies and start-ups, many of whose bank accounts shrunk as the tech sector crashed in 2022. A failed stock sale sparked a panic among investors, leading to a bank run that ultimately crushed SVB. And another major reason was that Silicon Valley Bank ignored duration risk.
The bank received a windfall of new deposits during the early stages of the pandemic, and it took that money and invested it in long-duration fixed-income assets like Treasury bonds and mortgage-backed securities. The problem with that strategy was that the price of those bonds plunged as interest rates spiked over the past year.
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Because it needed funding due to the cash burn in its deposits, Silicon Valley Bank sold a portion of its bond portfolio at a deep discount -- a red flag for its depositors and investors. That helped prompt the bank run, and the rest is history. Now, the bank is being sold for parts, with First Citizens BancShares as the primary buyer.
The collapse of Silicon Valley Bank offers a valuable learning opportunity about duration for investors, especially as the topic was essentially irrelevant for a decade, when interest rates were near zero.
What is duration?
In investing, duration measures how an asset moves with respect to changes in the underlying interest rate. It's tied to when investors can expect to receive cash from the asset, whether through dividends with stocks or by receiving interest and principal payments with bonds.
In general, higher interest rates lower the value of most assets, but longer-duration assets like long-term bonds and growth stocks, especially unprofitable ones, tend to see the sharpest decline in value. Long-term bonds see their prices decline because in a market environment like the current one, investors can buy newer Treasuries with a higher coupon rate. That means that older Treasuries with lower coupons are worth less, and their prices fall to reflect the math behind the change in interest rates.
Because equities, unlike bonds, theoretically have no end to their cash flow, they have even longer duration than bonds, and they're sensitive to interest rates for similar reasons. When interest rates rise, investors tend to rotate their money from stocks into bonds, since bonds become more attractive because they pay more. Longer-duration equities like growth stocks are even more sensitive because the discount rate rises in the discounted cash flow model, which is the most popular way to value stocks, meaning that long-dated earnings, or earnings in the distant future, are worth much less than they were before.
Why is everyone talking about duration?
It's been more than two weeks since Silicon Valley Bank collapsed, but duration risk remains a hot topic in the investing world. That's because Silicon Valley Bank isn't unique in holding long-duration assets, and many banks, real estate investors, and others are facing a similar challenge, though not to the extent that Silicon Valley was.
At the recent FOMC press conference, Federal Reserve Chair Jerome Powell downplayed the duration risk elsewhere in the financial sector, arguing that Silicon Valley Bank was a unique case. Referring to SVB, he said, "This was a bank that was an outlier in terms of both its percentage of uninsured deposits and in terms of its holdings of duration risk."
Powell also said that Silicon Valley Bank's management "failed badly," and that they took on significant liquidity and interest rate risk and did not hedge against it.
The Fed chair may be correct that the banking failures will be limited to Silicon Valley Bank and Signature Bank, which collapsed due to its exposure to a similar base deposit base and was also the victim of a bank run.
However, the Fed also raised rates again at its meeting and expects to do another 25 basis-point hike later this year.
Given that the benchmark federal funds rate has jumped nearly 5 percentage points in just a year, investors should be prepared for further consequences. If you're overly exposed to long-duration assets, shifting some resources to shorter-duration assets like short-term bonds or high-yield dividend stocks could be a good idea.
Even if you don't adjust your investing strategy, be prepared for more volatility, as the banking crisis has introduced another significant risk to the stock market on top of high inflation, rising interest rates, and the threat of a recession.
