It took years for scientists to realize that not all cholesterol is bad. It’s time for the market to make the same distinction about debt.
Yes, corporate America has been rushing to borrow, causing consternation among some market watchers. In 2015 alone, America’s 1,500 largest corporations (not counting financials, which use debt very differently; we’ll exclude those from now on) issued more than $500 billion in new debt, easily exceeding the pre-financial crisis peak of nearly $350 billion. That’s a lot of fat on the bone.
But critics ignore the big picture: In the end, the total amount of debt matters far less than the ability to repay it. And there is no indication that companies in the Standard & Poor’s 500 index will struggle to make their payments now or in the future.
How can we be so jaded about debt? The financial crisis, after all, was caused by American homeowners borrowing too much money to buy homes they couldn’t afford, while January’s stock market slump was caused by fear that energy companies are forced to declare bankruptcy en masse.
Don’t tar all the companies in the S&P 500 with the same brush. For many energy companies, low oil prices have made it difficult to earn enough money to pay the interest on their high-yield bonds. For S&P 500 companies, that doesn’t seem to be a problem. The benchmark interest coverage ratio – defined as net income divided by interest payments – stood at 9.4 times in the last quarter of 2015, well above the long-term average of 6, 5 times, according to Morgan Stanley data. And interest expense is just 3.9% of total debt, near its lowest level on record, thanks to the Federal Reserve’s ultra-low interest rate policy.
At the same time, the companies have made sure that they won’t have to pay the money back anytime soon. According to Deutsche Bank strategist David Bianco, nearly 90% of total S&P 500 debt is long-term and due in seven years or more, and these companies have three times as much cash as short-term debt. “I wouldn’t be impressed if they did a one, three or five year loan,” he says. “They’re locking it in for the long haul.”
As a result, even a Fed rate hike — something that seems increasingly unlikely this month after Friday’s disappointing jobs data — would do little to hurt the balance sheets of S&P 500 companies. 15% of the S&P 500’s $3.6 trillion long-term debt is rolled over every year, and even if rates were to rise one percentage point, the impact on earnings would be only 50 cents a share , believes Bianco. “I see corporate balance sheets as a source of stability rather than a threat to the economy,” he says.
Nor should it threaten the stock market. Morgan Stanley strategist Adam Parker looked at last year’s debt issuance and found that just 44 companies accounted for 80% of the debt issued. Many of them were low-risk companies such as
(V), who have plenty of money to repay their loans. The healthcare sector was another major source of borrowing, as companies like
(GILD) took on more debt, adding leverage where there was little before. The rest came from companies like
(CVX), which do not fit easily into any box. “We just don’t think this issuance data is really important in predicting market-level performance,” Parker says.
For investors, however, a company’s ability to pay can be the difference between picking a winner and losing big bucks.
Leverage ratios, which measure the amount of debt relative to some form of asset, do a poor job of predicting future earnings – companies with the lowest debt ratios barely outperform those with the lowest. higher on an annualized basis. Coverage ratios, which measure a company’s ability to make payments, do a much better job: Companies with the highest free cash flow to debt ratios outperformed those with the lowest by about five percentage points.
That means investors shouldn’t worry about a company like
(MCD), which has six times more debt than equity but has an interest coverage ratio of 10.5 times. same for me
United Parcel Service
(UPS), which are heavily in debt but should have no trouble making their payments.
Nevertheless, investors should not be lulled into thinking that companies are low risk simply because they have low leverage ratios.
(RIG), for example, has a net debt to equity of 38% but an interest coverage of only 4.1 times. Others with low leverage ratios but low interest coverage include
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