As interest rates rise, companies with significant amounts of floating rate debt on their books have been lagging the market recently, according to Goldman Sachs Group Inc. (GS). However, they have identified a potentially high return, short-term tactical trading strategy related to these companies. "These stocks should struggle if borrowing costs continue to climb, but may represent a tactical value opportunity for investors who expect a reversion in [interest rate] spreads," Goldman says. (For more, see also: 8 Threats to the Market in 2018.)
Goldman identifies 50 companies in the S&P 500 Index (SPX) with high levels of floating rate debt relative to total debt. Among them are these 12, with their total debt in billions of dollars, floating rate debt as a percentage of total debt, and year-to-date price changes through the close on April 3:
- The Walt Disney Co. (DIS), $26 Billion, 8%, -7.5%
- Viacom Inc, (VIAB), $10 Billion, 13%, -4.5%
- General Motors Co. (GM), $94 Billion, 8%, -9.9%
- PepsiCo Inc. (PEP), $48 Billion, 9%, -9.8%
- Qualcomm Inc. (QCOM), $23 Billion, 10%, -14.4%
- Lowe's Cos. (LOW), $17 Billion, 6%, -8.1%
- Colgate-Palmolive Co. (CL), $7 Billion, 21%, -6.0%
- Molson Coors Brewing Co. (TAP), $11 Billion, 5%
- Dominion Energy Inc. (D), $37 Billion, 8%, -10.3%
- Aetna Inc. (AET), $9 Billion, 7%, -6.4%
- Deere & Co. (DE), $41 Billion, 12%, -2.2%
- General Electric Co. (GE), $135 Billion, 14%, -24.8%
Data on debt is per Goldman as of March 29. The medians for the 50 companies on the list are $14 billion of total debt and 9% of that being floating rate, versus $7 billion and 0%, respectively, for all non-financial S&P 500 companies. The S&P 500 was down by 2.7% YTD through the April 3 close. Goldman's report, "US Macroscope: Stocks with floating rate debt struggle as borrowing costs rise," was dated April 2. (For more, see also: 9 Stocks That Can Outperform As Bull Market Ages: Goldman.)
Goldman's Strategy in Detail
The strategy hinges on the expectation that the benchmark 3-month LIBOR interest rate has been inflated by "temporary supply and demand technicals" in the opinion of Goldman's credit strategists, rather than by increasing default risk among borrowers. In fact, former Federal Reserve Chair Alan Greenspan once called the LIBOR-OIS spread "a barometer of fears of bank insolvency," as quoted by Goldman.
At a recent rate of 2.3%, the 3-month LIBOR rate is at its highest level since 2009 and more than 100 basis points (bp) above its average for 2017, Goldman notes. Also, the LIBOR-OIS spread is currently at its widest since early 2012, shooting up from roughly 10 bp to 60 bp since the start of 2018. All this is significant for Goldman's strategy since LIBOR determines the current interest rate on many floating rate debt instruments.
'Recommend Strong Balance Sheets'
Goldman hastens to add that this short-term tactical strategy deviates from their longer-term view. "From a strategic perspective, the backdrop of elevated corporate leverage and tightening financial conditions drives our continued recommendation to own stocks with strong balance sheets," they write. The median S&P 500 company has net leverage of 1.7 times EBITDA, the highest level ever recorded, per Goldman, while the median company on their high floating rate debt list is rather riskier, with a ratio of 2.4 times.