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Is a Debt Bomb Ticking?

Nellie S. Huang, Senior Associate Editor, Kiplinger's Personal Finance

If debt lights the fire of every financial crisis, as author Andrew Ross Sorkin once observed, then we may have a problem brewing. Companies have loaded up on a record amount of debt in recent years, thanks in part to rock-bottom interest rates. Most market watchers don't expect the buildup to trigger an imminent credit disaster. Still, investors should be aware of risks that are building and choose carefully as they invest in bonds or stocks.

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Years of low interest rates have fueled a decade-long economic expansion and a bull market in stocks and bonds, and such ideal economic and market conditions have been perfect for borrowing. The value of outstanding IOUs issued to investors and other institutions by large, non-financial U.S. companies--$10 trillion, reports the St. Louis Federal Reserve--has nearly doubled over the past decade. That's equivalent to half the country's gross domestic product.

Many firms have used the borrowed money to fund acquisitions. For example, CVS Health borrowed $45 billion to acquire Aetna in 2018. Others have issued debt to fund share buybacks--including Apple, which launched a massive bond offering in 2013. Still others have borrowed to make or bolster dividend payments.

But there's a fine line between smart borrowing and overextension, and some market watchers see worrisome signs. The quality of the debt is one issue. Half of all high-quality corporate debt is rated triple-B, the lowest rung of investment-grade credit. When triple-B-rated companies slip up, they risk a rating downgrade to "junk" status, which can stoke investor fears and send the bond market reeling.


Another worry is that yield-starved investors have become complacent about taking on greater risk to eke out higher fixed-income returns, only to be unpleasantly reminded of the consequences when the economy sours. Finally, some analysts fear that firms borrowing to fund share buybacks or dividends instead of reinvesting in the company are putting short-term interests ahead of long-term growth. "Debt isn't necessarily bad," says Capital Group investment specialist Dale Hanks. "It's about how it's utilized."

Risks of a credit crunch remain muted as long as interest rates stay low and the economy hums along. But if rates rise or business slows, firms with hefty debts may have to sell assets or cut dividends to cover their obligations. If the country falls into a recession, some firms may default, which can send financial markets plunging.

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Fortunately, interest rates should hold relatively steady for now. The Federal Reserve said in late 2019 that it does not plan to raise rates until after a significant and sustained uptick in inflation. Says Capital Group's fixed-income specialist Margaret Steinbach, "Rates will be lower for longer and longer and longer." Nonetheless, investors wary about the risks embedded in the corporate-debt bender can shore up their portfolios with that in mind. (Returns, prices and other data are through December 31.)

Bond investors

Build a core. A well-balanced portfolio needs a core bond fund for ballast. A true core bond fund holds mostly A-rated debt and no more than 5% of assets in high-yield bonds. The managers at Baird Aggregate Bond Fund (symbol BAGSX, expense ratio 0.55%) buy only investment-grade bonds. More than half of the fund's assets sit in triple-A-rated debt, including Treasuries and government-backed mortgage securities. The rest of the fund's holdings include high-quality corporate debt (40%) and other asset-backed securities (8%). The fund yields 2.09%, which may not impress income seekers, but its main role is to hold up in hard times. Consider it an insurance policy against a recession.

Beef up your safe havens with other government bonds. Agency mortgage-backed securities come with the same guarantee of Treasuries and a touch more yield. Stable interest rates should keep prepayments--a risk with mortgage debt--at bay. Vanguard Mortgage-Backed Securities comes in an exchange-traded-fund share class (VMBS, 0.05%, share price $53) and a mutual fund class (VMBSX, 0.07%). Both hold only triple-A-rated mortgage bonds. The ETF yields 2.55%, and the mutual fund yields 2.53%, a tad more than the typical core bond fund.

Move up in corporate quality. Everything worked in fixed-income markets last year. Take some profits in junkier debt and bolster your exposure to higher-quality bonds. IShares AAA-A Rated Corporate Bond ETF (QLTA, 0.15%, $55) offers exposure to the highest-rated corporate IOUs and yields 2.42%.

Try emerging-markets bonds for extra income. This isn't the risky sector it once was. Today, more than half of the emerging-markets bond universe is investment grade. The dollar isn't as strong as it was in late 2017 and early 2018. In fact, it was relatively stable in 2019 against a basket of foreign currencies. And many analysts expect it to weaken this year. "Dollar weakness is positive for EM assets because governments and companies have a lot of dollar-denominated debt. When the dollar rises, it's like a tax," says Alec Young, FTSE Russell's managing director of global markets research. And when it weakens, it's like a rebate.

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Be prepared for volatility. The ride with emerging-markets bonds is twice as bumpy as the typical core bond fund. But securities in this sector, on average, yield twice as much. iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB, 0.39%, $115) yields 4.31%. This ETF sidesteps the impact of currency swings by buying dollar-denominated bonds. For a boost in income, you could pair your dollar-based ETF with the version that invests in IOUs in local currencies, iShares J.P. Morgan EM Local Currency Bond ETF (LEMB, 0.30%, $44), which yields 5.50%.

Stock investors

See what supports your dividends. Avoid companies with a lot of debt. Pro­fessional stock (and bond) pickers scrutinize balance sheets and income statements to get a sense of whether a company has the wherewithal to pay its debts--because if it comes to a choice between making a debt payment or paying a dividend, the former will always win. "Understanding what a company intends to do with its debt and how it intends to pay it down is paramount to what we do," says Capital Group's David Bradin, an investment specialist at American Funds.

Consider two auto­makers, Ford Motor and Daimler AG. Both offer similar dividend yields: Ford, 6.37%; Daimler, 6.46%. But Ford has a triple-B credit rating and Daimler is rated single-A. Moreover, Daimler generates enough in annual operating income to pay its yearly interest expenses 13 times over. Ford throws off enough to pay three years' worth of interest payments. "Investors can jump to a conclusion that two companies in a similar industry with similar yields are the same," says Capital Group's Hanks. "But one has more risk than the other, and its dividend could get cut. You might want to ask yourself, Am I getting paid for the risk I'm taking?"

Choose a dividend pro. At Vanguard Equity-Income (VEIPX, 0.27%), two firms run the fund but work separately, homing in on large, high-quality firms with above-average yields. The fund yields 2.70%. Schwab U.S. Dividend Equity ETF (SCHD, 0.06%, $58) isn't actively managed, but the companies in the index it tracks must meet several criteria. Firms must have paid dividends for at least 10 consecutive years, for starters. And only firms with the best relative financial strength, marked by their ratio of cash flow to total debt and their return on equity (a profitability measure), make the final cut. The ETF yields 3.11%. Vanguard Dividend Growth (VDIGX, 0.22%) yields just 1.84%, but manager Donald Kilbride focuses on cash-rich, low-debt firms that can hike dividends over time. Morningstar analyst Alec Lucas says the fund is "a standout when markets tremble."

Add a dash of high quality. A strong balance sheet--one that's low in debt--is a key characteristic of a high-quality company. It's right up there with smart executives at the helm and a solid business niche in its industry.

Double down on high quality with iShares Edge MSCI USA Quality Factor ETF (QUAL, 0.15%, $101). The ETF invests in a diversified group of 125 large and midsize firms that have low debt, stable annual earnings growth and high return on equity. Johnson & Johnson, Pepsico and Facebook are among its top holdings. BlackRock has an international-stock version of this ETF, iShares Edge MSCI International Quality Factor ETF (IQLT, 0.30%, $32), that held up better than the MSCI ACWI ex USA Foreign-Stock index during the 2018 correction. The ETF yields 2.31%, and top holdings include Nestlé and drug company Roche Holding.

Go abroad. Companies in the rest of the world are less indebted, on average, than firms in the U.S. Even better, if you focus on the best players overseas, you might beat the U.S. stock market, says Capital Group's Robert Lovelace. "A majority of the best-performing stocks over the past 10 years were companies based outside the U.S."

At Fidelity International Growth (FIGFX, 0.99%), manager Jed Weiss focuses on firms with a competitive edge. If a company can raise prices for its goods without a drop-off in demand, Weiss is happy. That's a trait that can buoy a business in rough times.

WisdomTree Global ex-U.S. Quality Dividend Growth (DNL, 0.58%, $66) invests in 300 dividend-paying companies in developed and emerging foreign countries. The fund yields 2.6%. The firms must meet certain quality and growth bars, including return on equity and return on assets (another profitability measure), to be included in the fund. As a result, the portfolio has an average debt-to-capital ratio of 29--less than the 34 ratio of the MSCI ACWI ex USA index (and 44 for the S&P 500). The U.K., Japan and Denmark are its biggest country bets.

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Copyright 2020 The Kiplinger Washington Editors