One of the earliest lessons I learned as an investor was to stay away from debt. Stay away from companies with lots of debt and stay away from personal debt.
Getting into debt is one of the easiest ways to get into financial trouble, both for companies and individuals. If debt is not kept under control, it can quickly snowball into something terminal.
Just as the power of compound interest can transform an individual's financial circumstances, compound debt interest can destroy a creditor's financial circumstances.
However, not all debt is created equal. For example, mortgage debt is usually far more sustainable than credit card debt. Not only is mortgage debt tied to a solid asset, but interest rates tend to be low and predictable. The same is not true for credit card debt.
And it is the same for companies. A large, unsecured, floating rate revolving credit facility will be a more pressing liability than a 50-year bond paying a 2% coupon.
Further, one must consider a corporation's reputation with the market when analyzing its debt. A high-flying blue-chip company will not only be able to borrow at lower rates from a broader array of creditors, but it may also be able to issue new shares to the market without incurring significant costs (Tesla (TSLA, Financial) is perhaps the best example of success when it comes to being able to fund itself with large share issuances). In this scenario, a company's debt situation could be far more sustainable because of the positive market sentiment towards the business.
Debt affordability
Debt is no longer a zero-sum game. It was relatively straightforward to analyze how much debt was too much in the pre-internet era. Companies relied on hard assets. A firm could only borrow so much against hard assets before its creditors start to walk away. Creditors wanted to be sure they could sell assets in a liquidation scenario to cover debts. If liabilities exceeded assets, they may stop lending.
Today, this simple formula is not really relevant. How does one analyze the capacity to borrow of a company like Microsoft (MSFT, Financial), a business that has a huge amount of intangible capital? Ever-lower interest rates have also made it possible to not only hold larger amonts of debt on balance sheets, but even to borrow more money to pay off existing debts.
In this scenario, it may be better to look at debt affordability. This is the ability for the company to pay its debts back using different interest rate calculations. There has always been a space for this method of debt analysis, but today it seems to be more relevant than ever.
Rising interest rates could be one of the biggest challenges companies will face this decade. These companies have been able to continually roll over low-cost debt for the past 13 years. They may no longer be able to find a market for this debt. As such, they may have to pay more. For companies with large amounts of debt, paying an extra 1% or 2% in interest per annum could devastate them. If costs start rising, it could become harder to find lenders. That could force the company to have to offer more in the way of interest, setting off a downward spiral.
Debt has always been an integral part of the investment analysis process, but it is now more important than ever to consider this issue. The combination of more than a decade of complacency as well as the potential for higher interest rates going forward could be deadly for companies that have been reliant on increasingly cheap financing for the past 13 years.
There is no guarantee that interest rates will increase. Nevertheless, it will always be important to consider debt costs, debt levels and affordability when reviewing investments. Considering the risks and challenges that high levels of debt can force on a business, ignoring this could be a grave error for complacent investors.
