Entering 2016, consumer staples stocks made up approximately 10% of the S&P 500 index. That 10% figure, give or take a percentage or two, has been relatively constant during the past decade. This makes sense because people always need to buy food, drinks and household items — demand for consumer staples isn't going away anytime soon. Still, there are signs that balance sheets among the industry's top companies are becoming too leveraged.

A company's ability to service debt isn't always easy to identify in the consumer staples sector. These companies tend to have very high asset turnover rates, which means book values are fluid and require stronger-than-normal cash flows to support — one of the reasons that consumer staples stocks trade at higher book value multiples than any other sector. Another problem is that it's difficult to anticipate how lower market disruptions will affect demand for well-established defensive companies.

Lenders, like investors, need to have realistic expectations about a company's expected future earnings, cash flow and viability. Even the top defensive stocks can take on too much risk.

The Role of Debt

Consumer staples companies take on debt for the same reasons as any other company: to expand, pay for capital expenditures (CAPEX) and raise quick money without diluting ownership. During the 2013 to 2015 period, consumer staples firms saw rising asset prices, stagnant wages, dropping commodity prices, very low interest rates and concerns about economic growth. These are excellent conditions for debt financing.

You might be tempted to think defensive firms, such as consumer staples companies, can carry large amounts of debt. After all, the consumer staples sector is defined by a presumed low price elasticity of demand, as defined by Morgan Stanley Capital International (MSCI) and Standard & Poor's (S&P). Low elasticity is simply an economic term that means the demand for a product tends to not change much when the price of the product changes, relative to other industries.

Low-demand elasticity is a fundamental concept in defensive stock investing, since industries with low-demand elasticity also tend to experience less volatility during economic booms and busts. Put another way, more reliable future demand means debtor companies have a stronger future cash flow with which to pay their bondholders.

Try not to confuse an industry's low-demand elasticity with that of an individual company, however. For example, it might be true that the demand for razor blades is relatively inelastic. It does not necessarily follow from that, however, that the demand for any one razor blade manufacturer is inelastic; there are many different razor blade manufacturers, and consumers can easily switch from one to another.

Debt Levels, 2006 to 2015

The decade between 2006 and 2015 saw the rapid rise, collapse and rebirth of leverage in the consumer staples sector. Among S&P 500-listed firms, the average debt-to-assets ratio for consumer staples companies was 25.45% in 2006. The ratio climbed to 34.47% in just two years, just as the Great Recession messed up the economy.

Debt levels dropped over the following few years. Despite huge interest rate cuts by the Federal Reserve, credit was more scarce in a skittish lending world. At the same time, asset prices recovered in 2010 and 2011, driving leverage ratios down. By 2011, the average debt-to-asset ratio for consumer staples companies was 27.05%.

That trend quickly reversed starting in 2012. The ratio rose quickly despite ever-increasing stock prices -- the S&P 500 gained more than 63% from the start of 2012 to the end of 2014. By 2014, the debt-to-asset ratio was 32.58%, or near pre-crash levels. It leverage accelerated another 10% over the next 12 months, ending 2015 at 35.57%.

What It Means

Consumer staples equity prices started approaching all-time highs in March 2016. Sector-wide, investors seemed enticed by the stock's defensive characteristics and above-average yields. After two-plus years of underperforming the broader market, the growth of consumer staples sector outpaced the S&P 500 in the first quarter of 2016.

Higher earnings and more investor demand make it easier to float higher debt levels, and they are welcome signs to the sector. Still, macroeconomic trends look gloomy for big-time bond issuers. Interest rates are above the zero-bound in the United States and may rise again soon. Global stock market volatility harms asset prices generally, but staples are well-positioned to absorb or benefit from it. If consumer spending slumps, expect the most-leveraged companies to struggle with valuations, cash flow and interest payments.

Investors should pay close attention to fundamental indicators, such as the interest coverage ratio or debt-to-capital ratio. Companies such as The Coca-Cola Company (NYSE: KO) and PepsiCo, Inc. (NYSE: PEP) tend to have stronger balance sheets in these respects.

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