Has Your Equity Fund Loaded Up on Debt?

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.

FPA US Value

FPPFX — Greg Nathan became the new lead manager here as of September 2015, coinciding with previous lead manager Eric Ende’s retirement. Nathan hasn’t wasted time, creating wholesale changes at FPA US Value (previously named FPA Perennial). He cut his teeth as an investor at contrarian-allocation fund

American Century Heritage Fund

TWHIX — This fund’s average debt/capital ratio increased 20% over the 12 months through December 2015. In addition, more than half of the fund’s picks have a debt/capital ratio that exceeds the mid-cap growth Morningstar Category average, demonstrating a consistent increase in debt over many of the fund’s approximately 100 holdings. For example, aluminum can producer

Longleaf Partners

LLPFX — Longleaf Partners’ Morningstar Analyst Rating was downgraded to Neutral from Silver because of missteps from several heavily weighted stocks. In addition to stock-price declines from