Average debt/capital ratios are returning to precrisis levels.
When investors fret about surging corporate-debt issuance and tightening credit spreads, most probably think first of their bond holdings. There’s good reason for this. The spread between corporate-bond (both investment-grade and high-yield) and Treasury yields is low, although not yet approaching the record levels set in 2007. As interest rates have remained low, companies have rushed to take advantage of cheap financing.
Although it’s possible that leverage will continue to boost equity returns, it also increases the chances for debt defaults down the road. While many bond managers say that things haven’t gotten out of hand yet, companies issued a record $1.47 trillion in debt last year, and issuance has stayed robust so far in 2014. To be sure, this record issuance is offset somewhat by corporate cash, which also hit a record $1.53 trillion in 2013.
Didn't We Just Have This Conversation?
Nevertheless, all that issuance ends up on company balance sheets. And rising debt levels could have an impact on their share prices, too. After a period of corporate restraint, average debt/capital ratios have returned to prior highs. The evidence is reflected in the average debt/capital ratios for U.S. equity fund portfolios. The average debt/capital ratio for Vanguard Extended Market Index VEXMX, which invests in small- and mid-cap stocks, hit 39% as of April 2014. (A fund’s average debt/capital ratio can be found in the Premium Details section under the Portfolio tab.) That’s greater than the prior 37.2% peak reached in June 2007. Vanguard 500 Index’s VFINX 35.3% average debt/capital ratio has also surpassed its June 2007 level of 35.1%.
From a market-cap perspective, the highest debt/capital ratios tend to be found among mid-cap funds. Mid-cap blend funds in particular have the highest average debt/capital ratio, at 38.6%, among the nine major U.S. equity categories. (Small-growth funds have the lowest at 29.5%.) In looking at debt/capital ratios among funds in the Morningstar 500, the funds with the five highest debt/capital ratios are all mid-cap offerings: Akre Focus AKREX (50.5%), Weitz Hickory WEHIX (50.0%),First Eagle Fund of America FEAFX (49.8%), Fidelity Leveraged Company StockFLVCX (48.0%), and Osterweis OSTFX (47.7%).
The 2007-09 credit crisis showed how much of a liability a highly leveraged balance sheet can be. And it wasn’t just the banks that suffered back then. Fidelity Leveraged Company Stock fell 54.5% in 2008, 15.4 percentage points more than the mid-blend average. Cash in the portfolio can provide somewhat of a bulwark in such cases. But, as was the case then, this fund doesn’t have much of a cash buffer if liquidity suddenly dried up again. Conversely, Weitz Hickory had 27% of its assets in cash as of March.
Don't Count on Quality Alone to Save the Day
A high-quality portfolio--as measured by companies with competitive moats or high returns on equity--is much discussed these days as a way of reducing risk. But the credit crisis also showed that a high-quality portfolio alone isn’t always enough, especially if those companies are loaded with debt. My colleague Mike Breen pointed this out in this classic piece following the credit crisis. That was certainly the case for Ariel ARGFX. Lead manager John Rogers is a big believer in owning companies with competitive moats, and it shows in the portfolio. Virtually all of the holdings that are covered by Morningstar equity analysts have a moat of some kind, although the vast majority of these carry narrow moats rather than wide ones.
But even with a fairly high-quality portfolio, the fund still lost 48.3% in 2008, 9 percentage points more than the mid-blend average. Part of the reason for this poor showing was the fund’s nearly 44% average debt/capital ratio in June 2008. Rogers and his team learned from this experience, though, and now require their holdings to have stronger balance sheets. As a result, the portfolio’s average debt/capital ratio has fallen to 38.1% as of March 2014, just below the mid-blend average.
It's impossible to know whether higher debt levels and rising valuations for stocks and bonds are a precursor to another credit crisis, or whether highly leveraged companies will be punished as severely during the next bear market. But investors should at least be aware of this risk and know where their equity funds stand. So, when assessing your exposure to an increasingly frothy debt market, make sure to check your equity, as well as your fixed-income, holdings.