Net debt and the debt net

Tom Traill - 14 November 2019

Corporate debt can be an accelerant for growth when used appropriately but can all too easily drag a company down when it gets out of control. The stockmarket rarely punishes a company for leveraging its balance sheet in a positive phase of the economic cycle, especially if the debt proceeds are used to shrink the equity base. If the company’s profitability is improving then there is little to suggest that a rising level of net debt is a hindrance to performance. However, the US record shows that companies with net cash on the balance sheet outperform those with net debt, come rain or shine. In adversity, debt is a deadweight, while cash represents optionality and opportunity. Even profit turns out to be an opinion, while cash is a fact. The Fed may have cut its funds rate three times this year, but this does not guarantee that the debt markets will continue to absorb issuance from all types of borrowers. 2020 is when the net closes in on unprofitable companies with net debt.
The post-crisis period has been a boon for the corporate credit market with Fed policy skewed to the compression of private sector borrowing costs. The international search for yield has validated the corporate fantasies of sound and unsound businesses alike, keeping the capital markets ‘open all hours’.  Here, we examine association of corporate debt on US share performance under different interest rate regimes.

Surprisingly, despite the growth of the corporate debt market in recent years and the downward trend in interest rates over the past three decades, the companies with the most debt have not, on average, seen the best share price appreciation. We have looked at a sample of the 1200 companies that have been in the S&P 500 over the past three decades – because of IPOs, mergers and other changes to the index this gives us a rolling cast of around 750 companies. The average price appreciation of these shares is around 14.2 per cent a year, but the cash rich subset of companies (those with negative net debt) beat the average at 24 per cent over the past 29 years. 

Intuitively, even accounting for the fact that the cash rich firms outperform on average, it might be assumed that periods when interest rates are falling will favour the debt-laded companies, as their debt service costs have further to fall, and the opposite to be the case when interest rates rise. In fact, the cash rich (negative net debt) companies outperform whether the Fed funds rate is rising, falling or remaining constant. In periods of rising Fed funds rates the companies with negative net debt typically appreciate twice as quickly as those with net debt, as figure 1 shows.

The October Fed meeting brought the third 25 basis but cut of the year, and the clear indication that the hurdle for further cuts was high.  However, even if the December meeting sees no change in rates as expected then Q4 will register as a rate cut quarter and we would expect net cash companies to outperform. As for 2020, if you sympathize with our view that there is a fracture to come in the corporate credit space, then that is a good reason to tread carefully and to avoid companies whose debt might be viciously repriced in such an event. Companies with negative net debt may offer a degree of refuge in such circumstances.
Whether you expect interest rates to grind slowly down to zero, or the Fed’s hand will be forced to raise rates, the data suggests that the companies with negative net debt are likely to see comparatively elevated returns.

The November edition of our publication Market Focus looked at this topic in more detail and with more parameters, if you are not currently a subscriber to Economic Perspectives and would like to see the article please feel free contact us to discuss a trial of our services. 

Figure 1: 

Data source: Thomson Reuters Datastream and EP calculations

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