In our August piece, The Solvency Debate Continues, KCR updated our 2021 missive Junk Stocks Funded by Junk Bonds. We observed that 2023 had seen speculators return with a ferocious appetite for low-quality stocks. Our focus in that piece, and again today, will be on a group of companies that failed the Federal Reserve’s test for financial fragility as defined by interest coverage ratios (“ICRs”). These are companies that cannot afford to pay the interest on their debt out of operating income.
We highlighted the following:
- The market cap of companies that could not afford to pay their interest expenses out of operating profits had soared to a new record of $2.2 trillion dollars
- The number of stocks that could not pay their interest expense was approaching 20% of all the listed stocks in the market – an all-time record
- That we felt this simple metric was a far better measure of financial health than waiting for rating agencies to tell you if the investment grade rating of a company’s leverage is high yield or not
Get our insights direct to your inbox: SUBSCRIBE
The purpose of today’s piece will be to explain in simple and clear terms the devastating impact rising interest rates have yet to inflict on these stocks. Many of these stocks have large amounts of debt maturing in the next few years. The higher interest rates at which these companies will have to refinance their debt have created a potential solvency crisis that their equity investors seem totally blind to.
Before diving in, the chart below shows the year-to-date performance of (in order of appearance):
- The Russell 1000 Growth Index, the firms that cannot pay the interest on their debt (Firms w/ ICR <1), the S&P 500 and the Russell 1000 Value Index
- Incredibly, the low-quality garbage has nearly matched the parabolic multiple expansion of high-quality growth stocks that has driven the R1000G Index
YTD Absolute Return