In constructing our US portfolio, one of the first screens that we perform on the S&P 500 is to exclude companies with non-investment grade debt. In order to be considered an investment grade issue, the company must have a credit rating of BBB or higher by Standard and Poor’s or Moody’s.
The simple screen shrinks our opportunity set to focus on companies with stronger balance sheets with appropriate amounts of debt. While taking on debt can be useful for companies to access capital and invest in the growth of their business, it can also be a burden if growth plans do not play out as expected. Companies are left with interest payments and obligations that can weigh on them and their ability to grow for years to come. The weight of these burdens become heavier in economic recessions.
In a recession, like the one brought on by the COVID-19 crisis, companies get squeezed as their revenues decline on the back of a weaker economy. Companies with weaker balance sheets are more susceptible to a bigger drawdown on their stock performance as they continue to have to pay their fixed expenses with lower revenues and face higher borrowing costs on account of their lower credit rating.
It is no surprise when looking at the graph below that through the COVID-19 crisis companies with better credit ratings have performed better.
Performance of S&P 500 Companies by Credit Rating
January 1, 2020 – May 15, 2020
Source: Citi Equity Trading Strategy (CETS), Bloomberg
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