Wall Street falls in love with companies loaded up on debt

Bloomberg

The Federal Reserve’s new round of interest-rate reductions just might be working. At least, that’s what one obscure, but key, stock market indicator suggests.
For the first time since 2016, companies with fragile balance sheets are outperforming their sturdier peers and the broad market, a pair of Goldman Sachs indexes show. That’s a clear sign that the rate cuts are shoring
up investor confidence in heavily indebted companies —the segment of corporate America that’s most at risk to any downturn that hits the US economy.
The outperformance is so stark that a pure measure of leverage is the top equity factor this year among 10 styles tracked by Bloomberg. It’s a big turnaround for traders who had recently pushed relative valuations for financially solid firms to a 16-year high.
The change in heart comes as the Fed seeks to stoke growth by reducing borrowing costs, reacting to signals that the US economic expansion is slowing. With long-term Treasury yields reaching a record low last month, investors may be betting that all that inexpensive debt financing will help those companies expand and drive future earnings growth.
“Money is a lot cheaper to borrow and close to free in some cases,” said Sylvia Jablonski, the head of capital markets at Direxion, which manages $13 billion. “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.”
Take the performance of Edison International and Carmax Inc, for example, members of the S&P 500 Index with some of the highest ratios of net debt to earnings, according to data compiled by Bloomberg. Both are up more than 30 percent this year, trouncing the S&P 500’s 18 percent return.
That’s not to say there’s hasn’t been a ton of hand wringing about soaring corporate debt levels and the fallout to come when things go south. Even the Fed’s rate cut, while helpful in the short term, runs the risk of merely delaying the reckoning that will surely arrive for overzealous borrowers.
Goldman Sachs pointed out that net leverage — which measures how much companies owe for every dollar of earnings after subtracting cash on hand — for the median company in the S&P 500 spiked to a record in the second quarter. JPMorgan also flagged growing debt levels this month as a risk, saying leverage metrics are worsening.
But rather than fret, equity investors are taking a chance on riskier firms. A Goldman Sachs basket of companies with weak balance sheets has bested a gauge of strong balance sheet firms for four straight months. Up 20 percent year-to-date, the group of firms with more fragile finances is on track to beat the S&P 500 for the first time
since 2016. One reason for the faith? Extremely low borrowing costs. A divided Fed cut interest rates for the second time in two months, reducing its federal funds target by a quarter percentage point to a range of 1.75 percent to 2 percent.
Interest rates in the US aren’t high compared to the pace of economic growth, a dynamic that means companies should be able to easily meet debt payments, according to Joseph LaVorgna, the chief economist for the Americas at Natixis.
“If yields remain under nominal activity, a broad-based pickup in corporate defaults is unlikely,” he said.
Companies have been on a refinancing tear in September, issuing bonds with lower interest rates and buying back more expensive securities. The US investment grade market, with about $155 billion priced this month, has already surpassed last September’s total, and more companies are looking to refinance with borrowing costs low.