U.S. Equity Funds Enter Uncharted Territory

A version of this Fund Spy was originally published on June 12, 2014.

When investors fret about surging corporate-debt issuance and tight 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. Corporate leverage has risen dramatically as a result.

Leverage can boost returns for equity shareholders, but 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 in 2013 and issuance has stayed close to that level in each of the years since.

Didn't We Just Have This Conversation? While corporate cash levels are also high and this new debt tends to carry low interest rates, all that issuance still 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 surpassed prior highs.

The evidence is reflected in the average debt/capital ratios for U.S. equity fund portfolios. The average debt/capital ratio for

section under the Portfolio tab.) That's well above the 37.2% level reached in June 2007.

From a market-cap perspective, the highest debt/capital ratios tend to be found among mid-cap funds. Mid-cap growth funds in particular have the highest average debt/capital ratio, at 45.8%, among the nine major U.S. equity categories. (Small-value funds have the lowest at 35.3%.) 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:

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, Osterweis had 18% of its assets in cash as of June 2016.

Don't Count on Quality Alone to Save the Day A high-quality portfolio--as measured by companies with competitive Morningstar Economic Moat Ratings 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 following the credit crisis.

That was certainly the case for

Plus, wide-moat stocks tend to trade at above-market price multiples, creating potential price risk. The Morningstar Wide Moat Index's average price multiples are higher than those of the S&P 500 across the board.

Conclusion Nevertheless, there hasn't been much of a comeuppance for companies with high debt levels over the past three to four years. True, the correction from mid-2015 to early 2016, which was triggered by the impact of falling oil prices on highly indebted energy companies, hit funds such as Fidelity Leveraged Company Stock (down 27.5% peak to trough from May 21, 2015 to Feb. 11, 2016) and Ariel (down 25.4%) harder than most peers (the mid-blend average fell 20.3%). But First Eagle Fund of America and Akre Focus both weathered the storm better than their average rival, dropping 19.5% and 14.3%, respectively.

So, the debt brigade could roll on for some time, but beware that risks are building for the companies adding leverage and the funds that invest in them.