US corporate debt compared to gross domestic product is near an all-time high, and this high level is worrying some market watchers that changes in interest rates or economic conditions could have ramifications beyond the fixed income markets.
The low interest rate environment of the past decade has encouraged corporate growth using debt, said David Green, principal and portfolio manager at Hotchkis and Wiley. While debt fueled growth, deleveraging slows that growth. This could prevent companies from raising dividends or buying back shares, with shareholders feeling the brunt of that decision, he said.
The current low interest rate environment could change, and rising rates will make it costlier for companies to refinance when those loans come due. That’s particularly troublesome because the fixed income market is facing a “wall of maturity” between now and 2023, said Charlie Dreifus, manager of Royce & Associates Special Equity mutual fund.
“Quality didn’t matter. Lower quality [companies] actually did better. There will be a time where cash will not be a four-letter word but debt will be. That has ramifications not only for the individual stock but entire market,” he said.
He said mutual funds that own leveraged loans could be affected as investors sell these mutual funds, since the funds will need to sell holdings to meet those redemptions. “They will have issues selling and that will have broader market repercussions. It’s hard to think how this will be a positive,” Dreifus said.
Both men spoke Thursday at the Morningstar Investment Conference in Chicago.
Amy Zhang, small and mid-cap portfolio manager at Alger mutual funds, is also wary of holding companies with too much debt in the current economic cycle, especially for small-cap firms where cash flow may not be stable.
“Cash is king for small companies. Leverage kills,” she said.
Green said some companies are starting to think about this “wall of maturity” and looking at when their debt comes due, trying to lengthen maturity and having a plan for this maturity wall. Additionally, more companies are trying to hold more cash to shore up balance sheets.
If the trend of companies starting to deleverage grows, not only could it mean they are not raising dividends on an individual basis, but the trend of share buybacks could slow. Share repurchases have hit record levels this year as companies use the windfall from recent changes in the tax code to put these tax savings to work. But one consequence of indebted companies deleveraging could be a slowdown in buybacks, Green said, although he added he hasn’t seen a wholesale reduction in companies cutting back share repurchases. An economic slowdown or a rise in interest rates could slow buybacks.
Companies that have tried to reduce their debt leverage have been penalized, he added. He gave the example of Discovery (DISCA), which bought Scripps in an all-debt deal. He said the firm told ratings agencies it would try to lower its debt to EBITDA after the purchases by not buying back stock.
“Their stock got hit hard last year,” he said.
When investors evaluate a company’s debt levels, Dreifus said it’s important they look at total liabilities such as leases, pension fund obligations, and deferred taxes, among other liabilities.
“People focus on interest-bearing, long-term debt. There are lot of other elements to leverage besides pure debt,” he said.The fund managers, all who have a preference for holding companies with little to no debt, admit there’s been a bit of an opportunity cost for them. Zhang said her funds’ return on equity could be higher if they owned companies with higher leverage. Still, she said, “I’d rather have the financial cushion for a rainy day.”