Does corporate debt have an impact on stock returns for investors?

Corporate debt is important in the effects it exerts on stock returns, especially in the way investors think and act on the risk profile of a company. According to a report by UNCTAD, by the end of the first quarter of 2023, global corporate non-financial debt had risen to a record $90 trillion, surpassing global GDP for the first time, indicating the unprecedented size of corporate indebtedness worldwide. Read on to learn more about the effects of corporate debt on stock returns.

Corporate debt as a factor determining stock returns

Corporate debt is a two-edged sword concerning stock returns. It can either act as a factor supporting stock growth or could lead to value erosion. Indeed, a lot depends on how a company manages its debt or uses the funds raised via corporate debt.

Positive effects of corporate debt

1. Leverage for growth: Corporate debt can provide the necessary capital for companies to invest in growth opportunities by expanding operations, entering new markets, or developing new product lines. When these investments materialise, they will lead to capital appreciation in the form of increased revenues and increased stock returns.

2. Tax advantages: The interest paid on corporate debt is tax-deductible. This may help reduce the company's taxable income and thereby boost its net earnings. This acts as a tax shield, increasing its profitability and hence stock performance.

3. Sign of confidence: Sometimes, borrowing funds can indicate to the investors that a company believes in its bright future and growth prospects. Investor sentiment thus improves, driving up the stock price.

Negative effects of corporate debt

1. Financial risk and distress: Higher debt increases financial risk for the company as it has to service the interest and other principal-related repayments, whatever the financial performance of the company. It may result in financial distress, more so in a period of economic downturn and thus hurt stock returns.
2. Reduced operational flexibility: Companies holding a large amount of debt could maintain lower flexibility to invest in new opportunities and move with changing market conditions. This might hamper growth and affect the stock negatively.
3. Investor perception: A high level of debt discourages investors because of the risky image the company carries. This, therefore, lowers stock valuations and returns.

Empirical evidence and theoretical perspectives

Insights from various theories and empirical research for this relationship between corporate debt and stock returns are presented below.

• Pecking order theory: Companies largely prefer internal sources of funding over external debt. If external debt is used by the companies, this might indicate a dearth of internal funds along with an increase in agency costs. Consequently, this may be capped by negative investor perceptions, with stock returns having a negative influence.
• Trade-off theory: This theory argues that companies have a trade-off between the reduction in tax because of debt and the financial distress cost. Optimal levels of debt will enhance company value and stock returns, but having a lot of debt will do the opposite.
• Empirical studies: There is mixed evidence on the impact of debt on stock returns from research. Different studies of Indian companies concluded that the deleveraged companies (those reducing debt) outperformed as compared to non-deleveraged companies in bearish market conditions. This, therefore, provides evidence that reducing debt can increase stock performance by reducing financial risk and increasing operational flexibility.

Practical considerations for investors

1. Debt level and ratios: This comes from basic financial indicators, such as the debt-to-equity ratio and debt-to-assets ratio, among others. These are very significant in describing the company's leverage and, hence, its financial health. High ratios may indicate excessive debt and potential risks to stock returns.
2. Reasons for debt: Underlying reasons for borrowing becomes essential when analysing debt. Debt raised for the purpose of expansion or growth is a good reason, while debt raised to refinance already existing obligations is a red flag with respect to the stability of the company.
3. Market conditions: Corporate debt and stock returns interact under market conditions. This suggests that during harsh economic times, companies highly geared to face the music, leading to a decline in stock returns. This scenario is not expected in a bullish setting.
4. Industry context: There are industry-specific norms for the debt that should be carried. For example, some industries naturally have more capital intensity and are therefore more indebted. Investors should keep this in mind when assessing corporate debt.
5. Management and strategy: Corporate management and strategy pertaining to the issuance of debt are going to affect the way they relate to stock returns. If management is effective in managing debt, this enhances returns, but if it is mismanaged, then the corporations fall into financial distress.

Conclusion

Corporate debt remains an important factor in determining stock returns, as it has the dual effect of being a growth booster and a source of financial risk. While the existence of debt in a company provides a better avenue for expansion and hence more returns, high debt also implies the possibility of financial distress and lower returns accruing to shareholders. Investors have to, therefore, test the level of debt in a company, its justification, along with the underlying strategy, using empirical evidence and concepts inferred from theoretical studies. By doing so, they can make informed investment decisions and optimise their returns in the stock market.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

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