Amid concern over recession in the US, what is the impact of high corporate leverage on equity performance?
- Inverted yield curves and plunging Treasury yields have rekindled worries about recession in the US
- In recessions and when interest rates are rising, the stocks of companies with lower levels of leverage generally outperform those with higher levels. It is mostly only in the initial stages of market recoveries that higher leverage pays
Renewed worries that high corporate leverage will cause a recession may be exaggerated as company debt levels are not necessarily as high as perceived (measured by debt-to-equity levels), while low interest rates mean the cost of servicing the debt is manageable given reasonably good profit growth. Equity returns, at least as far as debt is concerned, depend on GDP growth and interest expense. Depending on where we are in the economic and interest rate cycle, one factor may outweigh the other.
When interest rates are falling, highly levered companies should benefit more than lowly levered companies as interest expense will be declining. A falling fed funds rate, however, most often corresponds with the economy moving into recession. As corporate profits fall amid slowing growth, it becomes harder for companies with high debt-equity ratios to service their debt, irrespective of the interest rate, and they tend to underperform significantly.
Exhibit 1: The stock performance of low vs. high leverage companies
(relative performance of top versus bottom quartile companies based on leverage as measured either by the debt-equity ratio or the EBITDA-interest expense coverage ratio)
Data as 31 May 2019. DE = Debt to equity; CR = Coverage ratio. Portfolio constructed from MSCI USA index, rebalanced quarterly, grouped into quartiles based either on trailing twelve-month debt-equity ratio or coverage ratio. Relative price return, top vs. bottom quartile. Excludes financials and real estate. Source: MSCI, FactSet, BNP Paribas Asset Management
The results are almost exactly the opposite in an economic recovery: returns for the lowest quality companies best the higher-quality, defensive stocks that investors had turned to during the selloff. When interest rates are rising, the squeeze on margins can be offset by rising earnings growth.
The coverage ratio (CR) seems to be the better measure of leverage in determining the likely outperformance or underperformance of stocks. There is a wider divergence between the top and bottom quartiles based on this metric rather than the debt-equity ratio.
A more nuanced picture emerges when you evaluate the performance by sector. For example, industrials has been the most vulnerable to rising interest rates in this cycle, while utilities have been relatively immune. The sectors that had the most consistent performance during past slowdowns were materials and consumer staples.
Exhibit 2: Leverage performance by sector
(top quartile coverage ratio vs. bottom quartile)
Data as at 31 May 2019. Source: MSCI, FactSet, BNP Paribas Asset Management
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