Debt is a double-edged sword. It can fuel a company’s growth during good times, but can drag it down when the economy weakens, making it harder for some companies to pay it off.
While the U.S. economy is chugging along for now, there are some warning signals of a recession, and borrowing costs are rising for lower-rated companies. Both are reasons for investors to consider the stocks of less indebted companies.
Over the past two decades, corporate bond issuance has surged—along with a marked deterioration in the quality of debt. As of last year, there is more than $9 trillion of U.S. corporate bonds outstanding, more than triple the level 20 years ago. For the first time ever, there are now more corporate bonds rated BBB (the lower end of investment grade) in the U.S. than the highest-quality AAA bonds.
Many companies have been growing rapidly—and often returning value to shareholders through buybacks and dividends—on the back of this cheap, lower-quality credit, but now they have to borrow at higher costs.
The difference in yield, or the credit spread, between lower-quality and higher-quality corporate bonds has been widening since last year. That’s because investors now expect to be paid more for taking on riskier debt as the economy started flashing signs of recession. This could be a problem for companies that have borrowed a lot at lower costs in the past, since they can no longer refinance that debt at the same low rates they got in the past.
Analysis from Bernstein’s Sarah McCarthy shows that as the corporate credit spread widens, lower-leveraged stocks—those with less debt relative to their equity value and earnings—tend to outperform their higher-leveraged peers. What’s more, stocks with both less leverage and a higher credit rating outperformed even more.
“High balance-sheet quality stocks are a good way to protect against rising credit spreads,” McCarthy wrote in a June research note. This year alone, among the 500 biggest names in the MSCI World Index, the quartile with the lowest leverage has outperformed those with highest leverage by 2 percentage points across the board—and by 1 percentage point within sectors, noted McCarthy.
A simple screening in FactSet shows that the S&P 500 (.SPX) stocks with the lowest ratio of net debt to earnings before interest, taxes, depreciation, and amortization, or Ebitda, are mostly technology and health-care names, including Incyte Corp oration (INCY), Fortinet (FTNT), Take-Two Interactive Software (TTWO), Twitter (TWTR), and Electronic Arts (EA).
Still, not all highly leveraged stocks are bad. If a heavily indebted company can keep receiving cash flows in a stable manner during a slowdown, it might still be able to cover debt payments and maintain healthy earnings growth. However, if the company’s revenue depends more on the business cycle, it might have a harder time paying down debt when the economy is weak, and in turn see a disproportionate drag on earnings from high interest costs.
The S&P 500 stocks with higher leverage—and in cyclical sectors—include Deere & Company (DE), Harley-Davidson (HOG), TransDigm Group (TDG), Yum! Brands (YUM), and American Airlines Group (AAL).
Many ETFs that focus on the fundamental quality of stocks also include debt level as a key factor in the screening process. The Invesco S&P 500 Quality ETF (SPHQ), for example, tracks high-quality stocks in the S&P 500 that have high return on equity, strong growth in operating assets, and low financial leverage. The fund has climbed 19% year to date, beating the S&P 500 by more than 2 percentage points.
|For more news you can use to help guide your financial life, visit our Insights page.|