$10 trillion in corporate debt has become a ticking time bomb for the next credit crisis — but one group of stocks is best positioned to escape it

Reuters / John Gress

• Investors are closely watching the credit market for signs of strain, especially as a growing share of debt is amassed by companies with the weakest ratings. 
• Higher interest rates have put many of these companies at risk of defaulting on their debt.
• Lindsey Bell, an investment strategist at CFRA, has identified a clear group of losers — and winners — in the stock market if there’s another credit-induced crisis. 

As credit goes, so goes the rest of financial markets. 

The subprime crisis and the subsequent meltdown in 2008 serve as fresh reminders of just how important debt is to everything else in the system. 

A decade after the crisis, investors’ biggest concern is no longer household debt. After all, consumers de-levered and regulators stepped up to correct some of the bad habits that caused the subprime mortgage disaster. 

But outstanding corporate debt, which now stands at nearly $10 trillion, is where the red flags are more frequently hoisted.

Cheap borrowing costs in the post-crisis era fueled a corporate-borrowing binge that included companies with the weakest credit ratings.

For example, the share of corporate bonds that are BBB-rated — the lowest tier that is one downgrade away from junk — has risen above a record 40% of all corporate debt, said Lindsey Bell, an investment strategist at CFRA Research. Also, some investors have expressed concern that ratings agencies may have inflated of some investment-grade companies. 

Thanks to corporate tax cuts, a strong economy, and improving profits, many companies that would otherwise default have been able to continue meeting their obligations — until now. Corporations may only be able to kick the can so far down the road, and a real crisis could be on the cards if companies start defaulting. 

This means it’s paramount for stock-market investors to identify the companies that would struggle the most in such an environment.

"Upon a closer look, we found large-cap companies, classified as members of the S&P 500 index, are best positioned to weather a credit-induced storm," Bell said. 

The chart below, which she highlighted for Business Insider’s "most important charts in the world" feature, shows that there’s a clear difference between these large-cap companies and their counterparts in the S&P 600 Small Cap Index. 

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S&P 500 companies have lowered their ratio of net debt outstanding to EBITDA by 1.6 times (or by almost half) since the financial crisis, Bell said. And thanks to the lowered taxes on repatriated earnings, these companies now have more cash on hand to pay down debt. 

It’s a completely different story for S&P 600 companies. Their net-debt-to-EBITDA ratio has more than doubled since 2009 and was 1.5x more than their S&P 500 peers at the end of 2018.  Shayanne Gal/Business Insider

This split in fortunes could become a drag on small-caps profits — and there’s perhaps no metric more influential to stock prices than that.

Half of the small-cap companies have debt that comes due within the next five years, compared to 40% of the S&P 500. Some of them may be left with no choice but to roll over their debt at much higher interest rates than when they first tapped the credit market. And these borrowing costs will eat into their bottom lines.

"The good news is that the total amount of debt held by S&P 600 companies amounts to only 3.5% of that held by the S&P 500, so alone it isn’t likely to tip the economy overboard," Bell said.

She continued: "Regardless, small caps should work on deleveraging while the economy is still strong, because there is one reality about history, it repeats itself."

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Source: Business Insider – aoyedele@businessinsider.com (Akin Oyedele)