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Fund Spy

Has Your Equity Fund Loaded Up on Debt?

These three funds have boosted their exposure to heavily indebted companies over the last year.

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The article was published in the May 2016 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

Most U.S. companies have taken advantage of a low interest-rate environment since the financial crisis and have steadily layered on debt. Indeed, the average debt/capital ratio at large-cap funds has increased just over 20% during the five years through 2015. Meanwhile, growth-oriented funds have seen their debt/capital rise by about 30% over the same period. Some investors might be less concerned when the long-term debt is financed at record-low rates. However, additional leverage can reduce a company’s flexibility in the future. Specifically, if high debt levels remain when the recession arrives, refinancing would likely take place during a less-attractive rate environment. This also puts future cash flows, necessary for debt payment, at risk. In addition, management teams that accept a return on invested capital below normalized rates (because the cost of borrowing is low) potentially damp future growth rates. Low rates also enable a spike in mergers, but those represent another risk. As a result, fund managers decide if they accept the risk of temporarily higher levels of debt in exchange for future cost-savings and cash flow growth. We’ve selected three funds whose average portfolio’s debt/capital ratio ranks in the highest decile within the Morningstar 500 U.S. equity funds. These funds’ most recent portfolio data available show debt levels at least 20% higher than levels 12 months prior. There is certainly more nuance within the capital structure than just a portfolio’s average debt/capital ratio, so, from here, other security-level metrics considered include interest coverage, short-term asset/liability ratios, and free cash flows.

Gretchen Rupp does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.