The Great Financial Crisis (2008-2009) reminded us of the danger of too much debt. Leading up to the period, households took on increasing levels of debt, inflating the housing market and preceding a very steep and significant recession. During the pandemic, while many households deleveraged, corporate debt levels reached all-time records.
A recent Wall Street Journal article cited that nonfinancial companies issued $1.7 trillion of bonds in the U.S. last year, nearly $600 billion more than the previous high, according to Dealogic. By the end of March, their total debt stood at $11.2 trillion, according to the Federal Reserve, about half the size of the U.S. economy.
At face value, these are troubling headlines, but they only tell part of the story. Cash levels on balance sheets are higher than pre-pandemic, implying that net-debt levels have not increased as much as the headlines portray. Additionally, low rates make debt much more affordable. “Historically low interest rates also leave interest coverage ratios at the healthiest levels in decades,” according to a recent note by Senior Economist Jesse Edgerton at JP Morgan.
Many companies issued debt to refinance higher cost debt. By the end of last year, the average investment grade corporate bond yielded 1.74%, way down from the start of 2020 when the average bond yielded 2.84%, according to the Wall Street Journal.
That’s not to say all companies are in great shape. Some of the corporations hardest hit by the COVID pandemic are just starting to recover and many of these “epicenter” companies still have higher leverage but “we see little sign of worrisome leverage increases in the distribution of public companies,” said Mr. Edgerton.
Regardless of lower rates and higher cash levels, last year’s increase in aggregate leverage should not be dismissed. Greater debt will amplify the variability in a corporation’s future prospects and thus needs to be carefully considered as part of an investment portfolio’s risk.
We spend significant time stress testing the balance sheets of the companies held in the Haverford portfolios. Given our quality focus, a strong balance sheet and steady cash flows are requirements for inclusion in our portfolios. A number of the companies in our portfolios took advantage of low rates to raise debt, some to fund M&A, and some to create an extra cash cushion, among other purposes. Importantly, we also saw an increase in aggregate cash levels across portfolio holdings, leaving our portfolio holdings with healthy overall low net leverage.
Leverage magnifies risk. Quality Investing seeks to control risk.
Charts from J.P. Morgan note, “US: Hard to get too worried about corporate debt,” on June 17, 2021
