When a high debt can result to high returns
You must have taken a peek at this year’s billionaires who made it to the top of the list of those who added fortunes to their wealth. How many billions did they gain over the previous year’s figures?
Most investors think that having a high debt is undesirable and must be avoided. Naturally, they tend to see it as adding more risks to a company’s present exposures. And once that company defaults on its debts because of underperformance, it could fold up.
Nevertheless, high debt can lead to positive consequences. It can bring in greater returns, even offsetting the greater risks involved in the process.
The major reason why debt can improve overall returns is because it costs much less than equity. A firm can raise capital either through equity or debt, with debt generally offering a less expensive option. Hence, maximizing a company’s debt levels in order to generate higher returns on equity is more logical. It can lead to greater profitability, stronger share-price performance and increased dividend growth.
The proper circumstances
Admittedly, maxing out a company’s debt levels is not a wise move at all times. Businesses with highly seasonal performance and dependent upon the conditions of the general economic environment might encounter great difficulties if their balance sheets are heavily leveraged. During times of low returns, they may not be able to undertake debt-servicing steps, aggravating the company’s situation.
On the other hand, companies performing in sectors that offer strong, consistent and viable revenues should increase debt to comparatively higher levels to enhance the gains for their equity-holders. For instance, it is to the advantage of utility and tobacco firms to raise their debt levels because of their high level of earnings visibility and the relatively strong demand for their products.
During periods of low interest rates, it certainly makes sense for businesses to borrow as much as possible. The previous ten years provided such an opportune time to borrow, rather than to lend. Global interest rates have experienced such record lows, thus, leading many companies in various sectors to decrease their overall borrowing rates.
In the future, a higher rate of inflation is expected, portending higher interest rates. Although it could lead to increases in the cost of servicing debt, it should be compensated somehow by higher prices passed on to the end consumer. Moreover, a higher inflation rate will serve to diminish the real-terms value of debt. This can lead to increased levels of borrowing in the future.
Although increasing debt levels can also increase overall risk, it can be a viable step under the proper conditions. During periods of low interest rates, businesses with strong business models may enhance overall revenues by raising debt levels. And while higher interest rates may entail rising costs of servicing debt in the future, higher inflation may reduce the real-terms value of debts. Hence, investors can opt to buy stocks with a modest degree of debt exposure to optimize their overall gains over the long-term.