Heavily indebted companies pay the price

With huge daily lows and stock market recoveries alternating with dizzying frequency, it’s difficult to draw reliable conclusions about the market outlook.

But some fund managers and fund managers believe the coronavirus pandemic has exposed a long-overlooked market vulnerability: high levels of corporate debt.

Encouraged by the Federal Reserve’s promotion of ultra-low interest rates since the 2007-2008 financial crisis, companies have rushed to borrow money for years, and those that are able to do so have been rushing to borrow money for years. new..

Corporate debt has risen sharply before the current crisis and now exceeds $ 10 trillion among non-financial corporations, reports the Federal Reserve of St. Louis.

But until the last month or two, most investors showed little concern. In recent weeks, however, many heavily indebted companies have had their long-overlooked weaknesses exposed.

Companies that want to borrow must pay premiums above Treasury rates, and these premiums have risen to record clips. “People are more concerned about who they loan to,” said Charlie Dreifus, senior director of Royce Special Equity Mutual Fund, which tries to avoid heavily indebted companies and favors those with strong balance sheets.

Other mutual funds that take a similar approach include the John Hancock Global Equity Fund and the Franklin Mutual U.S. Value Fund. Exchange-traded funds that do include iShares Edge MSCI USA Quality Factor and the Schwab U.S. Dividend ETF

Stocks and funds that often focus on low debt and strong balance sheets staggered the whole market after the last financial crisis. But Mr. Dreifus maintains, “There will be an ‘Aha’ moment when people think balance sheets are important, debt servicing is important, and the underlying quality of business is important.

As another financial crisis is in full swing, that moment may be nigh.

Many heavily leveraged – or leveraged – companies haven’t been able to get credit in recent weeks, said Kenneth Emery, senior vice president of Moody’s Investors Service. And corporate borrowers who got the funds had to pay higher interest rates as the “spreads” between 10-year Treasury bill rates and corporate debt grew.

Scott Minerd, global director of investments at Guggenheim Partners, said in the recent market turmoil “all debt is affected”.

“The only period in the past 30 years where corporate spreads have been wider than they are now was from March 2008 to July 2009,” he said.

Problems with heavily indebted companies in the credit markets contributed to heavy losses in the stock markets. Goldman Sachs tracks the performance of two portfolios of 50 stocks, one containing stocks with strong balance sheets, the other with weak ones. In March, the strong balance sheet portfolio lost 7.9%. But the weak balance sheet portfolio was hit much harder, falling 21.2%.

The origins of the current high levels of corporate debt can be traced to the policies of the Federal Reserve after the financial crisis of 2007-2008. More recently, encouraged and often attacked through a president who said “I like debt” and who has bankrupted at least four companies, the Fed continued to promote floor rates. Some investors question these ten-year policies.

“The perpetuation of low interest rates has encouraged companies to increase their leverage,” said Paul Boyne, portfolio manager of Hancock Global Equity mutual fund.

Grace Hoefig, manager of the Franklin Mutual US Value fund, said many companies used debt to buy back stocks when the stock market was rising.

But now that their stock is cheaper, she says, they can’t buy anymore. “If you’ve used debt to buy back stocks at high levels, you don’t have the financial stability to buy back stocks now,” she said.

A company that has not taken on debt to buy its own shares is Dick’s Sporting Goods, said Ms Hoefig. The retailer relied on its own free cash flow, not its debt, she said: “They bought back shares without borrowing.” Ms Hoefig’s fund owns shares of Dick’s Sporting Goods, a notable company, she said, among small retailers, many of whom are threatened by online alternatives.

A large company that has maintained a strong balance sheet is Chevron, Mrs. Hoefig said. All oil companies suffered from the sharp drop in oil prices in March. But Chevron, which a year ago refused to take on huge debt to acquire Anadarko, is now in a good position despite the decline in its own share price, she said. “Now they’re sitting there with a very, very strong track record in an industry that’s collapsing around them,” Ms. Hoefig said.

Chevron stock has gone from a 52-week high of $ 127 to a recent price of just under $ 85, but that’s a far cry from the fall of heavily leveraged Occidental Petroleum, which fell in below $ 15 after peaking above $ 68 the previous year.