It’s back: soaring levels of indebtedness and escalating loan defaults are all over the news. But this time around, it isn’t subprime mortgage loans causing the ruckus—and your portfolio could be at risk.
The current offenders are corporations—notably, those in the United States and China—and their collective level of leverage is threatening to ignite another global recession.
Let’s take a look at what’s happening behind the scenes, and spotlight the main offenders…
Déjà Vu, All Over Again
In the 1980s, a leveraged buyout boom caused unsustainable levels of corporate debt, leading to a collapse of the LBO market, massive debt defaults, and boatloads of bankruptcies.
In the 2000s, subprime mortgages led to homeowner defaults and millions of foreclosures.
Now, corporations have racked up at least $29 trillion in debt – some of which will go unpaid. So far this year, 39 companies from the U.S. have defaulted, out of a global total of 51. At the current rate, the number of U.S. companies defaulting on their debt could surpass that of 2009, when more than 60 corporations failed to service their debts.
Much of this debt is junk-rated, having experienced a slew of downgrades from rating agencies over the past year or more. Fitch Ratings recently predicted that defaults in junk bonds will soon hit a two-year high.
Debt investors see a rocky road ahead, too. A recent survey by the International Association of Credit Portfolio Managers revealed that 85% of investors think that North American corporate defaults will surge over the next 12 months.
Recently, the International Monetary Fund disclosed that China holds $1.3 trillion in loans at risk of defaulting. Such a scenario could cost the country the equivalent of 7% of its GDP, according to the report.
The IMF warns that this situation is heightening “global financial stability risks”.
How Did This Happen?
Two specific economic conditions are responsible for this current crisis: Government monetary policy, and plunging commodities prices, particularly oil.
Since the Federal Reserve instituted quantitative easing in 2008, interest rates have dropped to almost zero – prompting corporations to borrow more and more “free” money. But, instead of using this cash to fund capital expenditures or research and development that could eventually boost earnings, the money has been used to acquire other companies, repurchase stock, and pay dividends.
While this seems like a good deal for investors, it really isn’t. The effects of this kind of activity are actually negative for shareholders, in two key ways…
For one thing, corporate earnings haven’t actually risen; value is being artificially inflated by stock buybacks, and investors are kept happy as borrowed money fuels dividend payments. Corporate spending on buyback programs has become so out-of-control that many companies are spending more on share repurchases than they earn.
Worse yet, corporate management tends to buy back shares when they are at their peak, instead of buying when shares are trading lower.
Another problem with ramping up buybacks and dividend payments in the absence of real earnings entails the level of debt being accrued by these companies. The consequences of high leverage are now being felt, as more companies become unable to service their debt.
The drop in oil prices has affected corporate debt levels, as well. Domestic oil companies borrowed heavily when oil was $100 per barrel, and paying interest on their loans was easy. As the price of oil has fallen below $40, however, the number of “Zombie” oil companies has exploded – and defaults in the oil patch are increasing every day.
The Worst Offenders in the Debt Bust: Energy and Retail
It’s no surprise that oil and gas companies are some of the most debt-ridden entities. Defaults and bankruptcies in this sector hog the daily headlines, and Fitch Ratings estimates that $40 billion worth of oil defaults will occur in 2016.
Not just small producers are going under. Mighty Energy XXI Ltd. (NASDAQ:XXI) recently filed for bankruptcy, having financed a huge acquisition with borrowed money in 2014, and Sandridge Energy (SDOC.PK) is also teetering on the edge of ruin.
In total, 63 North American producers have gone bankrupt since the beginning of 2015, according to Haynes and Boone.
Meanwhile, the retail sector is smarting from debt taken on for acquisitions, as well as lower earnings – due partly to the upsurge in online shopping. For this year, Standard & Poor’s analysts predict more retailers will default than in the previous two years.
Some retailers have been in trouble for a long time. Sears (NASDAQ:SHLD) has been being whittled away by hedge fund manager-CEO Eddie Lampert for years, and is now closing an additional 78 K-Mart and Sears stores. Meanwhile, Lampert continue to juggle the holding company’s debt.
J.C. Penney (NYSE:JCP), also in dire straits, has debt that greatly outweighs its market capitalization. The store has been doing poorly since a failed turnaround attempt in 2012 by Ron Johnson, the creator of the Apple retail store.
A recent study notes that many retailers are facing headwinds these days, and need to pare their store locations in order to survive. In addition to the two mentioned above, Macy’s (NYSE:M), Dillard’s (NYSE:DDS), and Nordstrom (NYSE:JWN) are also considered at risk.
Protect Your Portfolio
Now that you know the dangers presented by excessive corporate leverage, it’s time to do some digging into your portfolio and root out the losers. Here are some key issues to research about energy and retail stocks in particular – but you may want to extend this scrutiny to all your holdings, as well.
Debt: Take a look at a company’s debt-to-equity ratio for a quick fiscal check. While you’ll likely be hard pressed to find ratios at or below 0.4 – considered optimal by analysts – the lower the ratio, the better.
In the oil and gas sector, the biggest players will be the better bets. Companies like Exxon Mobil (NASDAQ:XOM) and Chevron Corp. (NYSE:CVX) have fairly low ratios, at 0.79 and 1.34, respectively, considering that the S&P 500 averaged 1.7 until very recently. These behemoths will also be in a better position to ride out the current low-price environment, as opposed to the smaller producers.
In the retail sector, Walmart (NYSE:WMT) sports a rather healthy ratio of 0.93, compared to Dick’s Sporting Goods’ (NYSE:DKS) 1.64 – which could be even higher at the end of next quarter if DKS buys newly-bankrupt Sports Authority’s assets.
Dividends/stock repurchases: Take a look at company earnings. Do they support the dividend you’re receiving? If not, borrowing may be supporting those payouts. The same goes for share buybacks – if it appears that the stock is being buoyed by lavish repurchase programs fueled by debt, you may want to purge this company from your portfolio.
As you perform your due diligence, remember that these are not the only criteria to consider when deciding on whether to buy, sell, or hold certain stocks.
Keep in mind, too, that a reasonable amount of corporate debt is not unhealthy. When indebtedness becomes a threat to a company’s existence, however, smart investors must act accordingly.