Record Angst Over Leverage Belies Outperforming High-Debt Stocks

(Bloomberg) -- Angst over corporate debt at all-time highs, spiking Treasury yields, and the worrisome aftermath of record stock volatility. Yet U.S. companies saddled with the most risky debt are outperforming as stocks head towards their best weekly run in half a decade.

Talk is cheap: A record net 24 percent of investors say that global corporate balance sheets are overleveraged, according to Bank of America Corp.’s February global fund manager survey -- even more than the height of the financial crisis.

Managers aren’t voting with their wallets, however. A Goldman Sachs basket of S&P 500 companies with the riskiest balance sheets are on track for the biggest weekly gain since January 2013, advancing 5.5 percent in the four days through Thursday compared to 4.3 percent for the main equity gauge.

Record Angst Over Leverage Belies Outperforming High-Debt Stocks

Less-leveraged stocks are only disappointing in the short-term. Investors discarded the bond proxy-stocks to buy U.S. Treasuries that paid higher yields, said Louis de Fels, a Paris-based fund manager at Raymond James Asset Management International.

“After many years of QE by the Fed and ECB, all shares were up and there wasn’t a lot of stock picking,” de Fels said by phone. “When 10-year yields increase to 3 percent, you’ll start to see people look very closely at the balance sheets of companies and weak balance sheets will start to underperform.”

Weak balance-sheet companies and the broader S&P Index were little changed in early Friday trading.

Some of the action may in part be explained by managers unloading short positions that paid off during last week’s selloff. The 50 most-shorted stocks in the Russell 3000 Index rose 6.2 percent headed for the best week since November 2016, according to a basket compiled by Goldman Sachs.

Indeed, within the Russell 3000, the weaker the rating, the higher the short interest. Companies rated eight levels below investment grade have an average short interest of 8.3 percent of shares outstanding, versus 0.1 percent for those with the highest rankings, according to IHS Markit data compiled by Bloomberg.

Record Angst Over Leverage Belies Outperforming High-Debt Stocks

In just five days, U.S. equity has mounted a stunning comeback, jumping 5.8 percent after the biggest nine-day slump since August 2015.

Despite the fact that risky balance sheets barely underperformed the broader market in the recent rout, they’re now leading the way back. The mixed messages could be a harbinger for another correction with valuations still lofty, said Derek Halpenny, European head of global market research at MUFG.

“In terms of risk appetite coming back this week, there’s lots of conflicting stories going on in the markets,” Halpenny said on Bloomberg TV. “Ultimately there are risks there that weren’t there a year ago, in terms of long-term yields and the debt problem in the U.S. becoming a problem for investors.”

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