Debt-free Stocks excel in High-interest rates | Espresso


Why are debt-free stocks better positioned in a rising interest rate environment?

July 22, 2022
Why are debt-free stocks better positioned in a rising interest rate environment?

Look around you. Don’t you feel that everything is a lot more expensive than it was? We aren’t talking about your parents’ era; we’re talking about as recently as last year. It turns out you aren’t the only one who has noticed that. Governments and Central Banks worldwide are grappling with the same problem – inflation.

To combat this problem of rising inflation, Central Banks have started to raise interest rates for the last few months. Bank of England raised their interest rates by another 25bps to 1.25% in early July, their fifth successive rate hike. The Federal Reserve also raised rates by 75bps in June, after the highest inflation numbers in the USA since 1981. The same sentiment was mirrored by the RBI when they increased rates by 50bps in June 2022 to 4.90%.

So, in this rising interest rate environment which is likely to continue, where can investors find solace and potentially beat the market? In such situations, debt-free stocks are better positioned to ride the interest rate storm as compared to their leveraged peers. 

Here is why:

  • They have no repayment obligations: Debt-free stocks (as the name suggests) have no external repayment obligations. Well-run debt-free companies may tend to feel pressure on their profitability during harsh macroeconomic conditions but seldom face solvency issues due to them not owing anyone anything. While this conservative approach may affect their growth in an environment where borrowing is encouraged, it definitely benefits them when the interest rates start to rise.
  • Singular focus on growth: As many loans sold these days are floating rate loans, the rising interest rates mean a higher interest obligation which means a higher outflow of cash. In challenging market conditions, leveraged firms have two problems to deal with – a) how do we continue to grow the top line? B) how do we service a more significant debt payout? Debt-free companies have one less problem to deal with and can singularly focus on the overall growth of the company.
  • Relatively unaffected by slowing conditions: Debt-free companies are comparatively unscathed by slowing economic conditions, as the profits generated are retained within the company after all costs are considered. E.g., For companies such as HUL, ITC etc., which are debt-free, tend to ride every economic cycle as their products are consumed by millions of people every single day.
  • Higher dividend payout ratio: Debt-free companies tend to pay a higher dividend yield as they have better free cash flows available for distribution (mainly due to their recession-proof business models, e.g. FMCG / Pharma), which helps in providing a source of passive income for the shareholders as well as reducing their average cost. In tough times, investors prefer going for such high dividend yield companies due to the stability they provide to a portfolio, as well as the additional source of income.
  • Better perception of the market: The perception of debt-free companies to the stock market and investors is that the company can sustain (and grow) operations with the cash it generates from within instead of relying on external sources of funding. This tends to attract more investors, which only points to an upward direction of stock prices in the long term.

To simplify it further, one should treat a debt-free company as a debt-free individual. The individual in discussion will:

- Have more security

- Take better decisions with their money

- Be able to afford better things they need

- Be mentally free

Now compare this with someone who has a large debt obligation. Given a choice, who would you bet your money on to succeed when the going gets tough?

Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Please refer the Risk Disclosure Document issued by SEBI and go through the Rights and Obligations and Do’s and Dont’s issued by Stock Exchanges and Depositories before trading on the Stock Exchanges. Brokerage will not exceed the Exchange prescribed limit.

Chandresh Khona
by Chandresh Khona

Product Offerings Head

A teacher, writer, travel buff and now Espresso's Product Offerings Head. Ten years here has allowed me to lead the digital team at Sharekhan. My true passion lies in stock market charts.