Why Debt-Laden Stocks Leading S&P 500 Risk Major Reversal

As the Federal Reserve cuts interest rates, borrowing costs for companies have plummeted, leading to the refinancing of old debt at lower rates, as well as encouraging the assumption of yet more debt. Meanwhile, shares of highly leveraged companies are outperforming both low-debt stocks and the broader market for the first time since 2016. Should the economy experience a significant slowdown, let alone slide into recession, servicing that debt is bound to become more problematic, sending shares of those debt-laden firms tumbling, according to several detailed stories in Bloomberg as outlined below.

"Leverage is not a winning stock picking attribute,” warned Sandip Bhagat, the chief investment officer (CIO) at Whittier Trust. “The higher the leverage, the lousier the fundamentals, the lower quality the company is depicting. Don’t get tricked by it,” he added.

Significance For Investors

S&P Global Ratings finds that the quality of U.S. corporate debt is declining rapidly. During the third quarter of 2019, S&P issued 164 downgrades and 64 upgrades. The ratio of nearly 2.6 downgrades to every upgrade was the worst since 2015, another Bloomberg article notes. Most of these rating changes applied to the riskiest segment of the corporate debt market, high yield debt, with 143 downgrades and 33 upgrades, a ratio of 4.3.

Despite the recent surge in downgrades, the overall ratings on corporate debt may be seriously inflated, a Wall Street Journal study concludes. A major factor leading to the 2008 financial crisis was overly optimistic ratings that gave investors a false sense of security about debt that ultimately cratered in value when the economy slipped into the Great Recession of 2007-2009.

Goldman Sachs calculates that net leverage for the median S&P 500 company hit an all-time record in the second quarter, per Bloomberg. Goldman calculated net leverage as the ratio of net debt to earnings, where net debt equals total debt minus cash balances. Meanwhile, JPMorgan recently warned investors about the risks of rising corporate leverage, the same article notes.

Nonetheless, Goldman's basket of S&P 500 stocks with weak balance sheets has outperformed their basket of strong balance sheet firms for four consecutive months, and is up by 20% year-to-date. Edison International (EIX) and CarMax Inc. (KMX) are among the most indebted S&P 500 firms, yet their shares are beating the market and have surged by 32.0% and 37.4%, respectively, year-to-date through Oct. 1.

These debt-heavy companies could run into trouble in an economic downturn. Michael Wilson, Morgan Stanley's chief U.S. equity strategist, is among the most prominent bears about the outlook for the U.S. economy and stocks. "Growth is slowing much more than many seem willing to acknowledge, and the risk of a recession has increased materially," he wrote in a recent report.

Looking Ahead

To be sure, many investors argue these concerns are overblown. Sylvia Jablonski, head of capital markets at ETF sponsor Direxion, which has $13.5 billion in assets under management, says, “Money is a lot cheaper to borrow and close to free in some cases. As long as that goes into the investment of the firm and helps the firm grow and increases capex in a positive way, then I think it could be something that’s positive for those firms.”