There has been a lot of talk about quality, bond-like companies in sectors such as consumer staples having been major beneficiaries of quantitative easing and the low-yield environment. These stocks with stable cash flows and dividends have been preferred by investors since the financial crisis, and consequently trade on a premium relative to the rest of the market.
But highly-leveraged companies have also benefited, as low rates have brought down the cost of debt. “Historically, companies burdened with the most significant debt loads have traded at about a 14% discount to the market on our composite value metrics. That discount tends to widen leading into and during recessions as cash flows dry up, interest coverage wanes, and defaults rise,” notes Neil Constable, head of global equities at asset manager GMO, in a recent paper.
Because interest rates have been low for so long, highly leveraged companies now trade near parity with the market, as shown on the chart, “offering no discount for their more precarious balance sheets”.
That leads one to conclude that perhaps the market hasn’t priced in the consequences of the Fed’s rate hikes for these companies. And Constable isn’t the only one who makes this point. Andrew Lapthorne, head of quantitative equity research at Société Générale, argues that smaller American companies now pay a larger percentage of their profits in interest than before the financial crisis, even though interest rate costs are now much lower.
“The US corporate debt bubble is likely to regain centre stage,” he told the Financial Times recently. “The problem the US now faces is that it has to normalise interest rates, but with the smallest 50% of US companies already spending 30% of profits on interest, any move upwards is likely to push up interest costs to dangerous levels,” he added.
“Interest payments have grown in line with EBIT (earnings before interest and tax), even as interest rates have fallen. This should be a clear warning sign to anyone familiar with the vicious dynamics of forced deleveraging,” Constable agrees.
Though there aren’t yet any signs of a recession that could bring about such forced deleveraging, highly-levered companies will find it difficult to cope financing their debt going forward. They will need an acceleration in earnings growth merely to keep stable interest spending as a percentage of profits.
Not only equity investors should be aware of these risks. Most of the excess debt issued by these companies in recent years is junk-rated, so high yield-bond investors would do well taking notice too.