Does Financial Leverage Make Stocks Riskier? 

Or asked differently, can companies boost returns via leverage?

September 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The leverage of US stocks has been increasing over the last four decades
  • The most leveraged stocks did not generate higher returns than the least leverages ones
  • However, they were also not riskier

INTRODUCTION

The IMF issued a warning on corporate debt in their latest Global Stability Report and highlighted the following concerns:

  • The estimated share of speculative-grade debt in the corporate sector is nearly 50% in the US as well as China and even higher in Italy, Spain, and the UK
  • The share of debt-at-risk, which represents companies where the interest costs are higher than EBITDA, aka Zombie firms, is above 25% in the US and the UK

The institution also provides an adverse economic scenario that assumes half of the GDP decline of the global financial crisis of 2009, which results in the debt-at-risk rising to $19 trillion, or 40% of the total corporate debt for the eight largest countries. It would be a Zombie apocalypse.

Unfortunately, this report was issued in October 2019 and the world has seen a much more dramatic decline in GDP in 2020 due to the COVID-19 crisis, compared to the IMF’s adverse scenario. For example, the UK’s economy contracted a mere 4.2% in 2009, but is expected to decline by 8.3% in 2020, according to a forecast from the European Commission.

Investors concerned with the outlook for the economy and the stock market may intuitively seek stocks that feature low leverage and hope for these to outperform in such an environment. However, investing is rarely straight forward and frequently almost illogical. For example, more volatile stocks do not generate higher returns than less volatile stocks, at least not a risk-adjusted basis, which is called the Low Volatility anomaly.

Perhaps financial leverage is not as risky as commonly assumed, which we will explore in this research note.

FINANCIAL LEVERAGE IN THE US

Looking back over the last few decades highlights that non-financial corporate debt as a percentage of GDP has been rising consistently in most countries. For example, the ratio was a mere 22% in the US in 1951, compa