Why Debt Levels Are The Biggest Threat To Investors

In the UK, we’ve become used to having low interest rates. In fact for many people, they’ve become the norm and some just don’t remember a time when rates were higher. However, an interest rate of 0.5% won’t last indefinitely and when the Bank of England decides to tighten monetary policy, the FTSE 100 could suffer.

Shock tactic

That’s the case for a couple of different reasons. Firstly, there’s the shock of a rate rise for individuals, businesses and investors. As mentioned, low interest rates are now seen as a ‘new’ normal and the end of that era could cause confidence to come under pressure. This has been the case in the US, where the Federal Reserve raised interest rates in December by 0.25% only for investor confidence to deteriorate and cause the S&P 500 to fall. The same thing could happen in the UK, since the first interest rate move in a new direction tends to be the one that has the biggest impact.

Secondly, despite the lessons of the credit crunch, the UK still has sky-high consumer and business debt levels. A higher interest rate could therefore not only shock consumers, businesses and investors, but also cause a deterioration in their financial outlooks. For example, individuals will pay greater monthly mortgage and other debt repayments and this could cause consumer spending to fall, while businesses may see their profit margins decline as debt servicing costs increase. And for listed companies, this could cause investors to become less positive regarding their long-term outlooks.

As a result of this, it seems prudent for investors to take debt levels seriously. Although some companies in certain sectors can live with higher debt than others, for example utility and tobacco stocks, their share prices may still come under pressure due to the prospect of slower-growing profitability. Likewise, companies that are more cyclical and that have relied on debt to boost return on equity in the past may begin to come unstuck if they endure a double threat of reduced sales (from lower consumer spending) and higher debt servicing costs.

Cash on the hip

Clearly, most companies have some debt on their balance sheet, so completely avoiding companies with debt when investing is very difficult. However, investors may wish to focus on companies that have a sizeable cash pile or that have a sensible amount of debt given the resilience of their business models.

One way of assessing this is to use the debt-to-equity ratio, which is where debt levels are divided by total equity. For more defensive companies, an acceptable level will naturally be higher than for a cyclical play. Alongside this, it may be worthwhile to check how many times a company is able to pay the interest on its debt by calculating the interest coverage ratio. That’s simply where operating profit (i.e. profit before interest and tax) is divided by interest costs, with a more resilient business likely to have less headroom than a more cyclical company.

So, while there are many risks facing investors, the one that could catch a lot of them out in the coming years is a rise in interest rates. While not on the near-term horizon, within five years interest rates could realistically be above 3% and therefore this risk needs to be taken seriously.

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