Executive Summary

The inconsistent relationship between value factor returns and changes in interest rates, strong in recent years but mixed historically, can be explained by the time-varying duration of a portfolio that is long cheap stocks and short expensive stocks.

• In a simple model, holding all else equal, low government bond yields cause the duration of expensive stocks to increase by more than that of cheaper stocks.
• This change in duration increases the sensitivity of the portfolio to changes in interest rates.
• A period of higher interest rates may see a moderation in the recent heightened sensitivity of the value factor to movements in interest rates.