A company can generate higher returns on equity if it increases its use of debt. When a company uses debt, its equity holders avoid risking additional equity because the new money is borrowed from others. Any future increase in returns (above the cost of debt service) accrues to the same equity base.
Of course, the interest payments that come with the debt add to the company's operating expenses and thereby reduce profits. However, as long as the company's cash flow can cover the interest payments, even a smaller profit margin can result in a higher return on the equity invested by shareholders.
Leverage can increase return potential to equity investors
Equities of a leveraged company can provide strong returns
Leveraged company equities offer the potential to outperform the stock market by a significant margin, particularly during a period of economic recovery. Since these companies use debt heavily, they tend to have their best performance when credit is available, interest rates are low, and strong economic momentum supports business earnings.
An example of such a period occurred in February 2003 at the end of the last bear market. The federal funds rate was approximately 1.25%, and economic growth accelerated from 1% to 7%. Leveraged company stocks nearly doubled the return of the S&P 500. High-yield bonds and bank loans also provided strong returns in the same period.
Leveraged companies posted strong results during the 2003 economic recovery (2/28/03 – 2/29/04)
This chart shows index performance during a period of strong returns for leveraged company stocks, does not reflect index performance during other time periods, and is for informational purposes only. It does not reflect the performance of any Putnam fund, which will differ. Leveraged company stocks are measured by the Credit Suisse Leveraged Equity Index, which includes companies that issue high-yield corporate bonds included in the Credit Suisse High Yield Bond Index; stocks are measured by the S&P 500 Index, a broad measure of stock market performance; high-yield bonds are measured by the JPMorgan Developed High Yield Index, which represents high-yield fixed-income securities issued in developed countries; and bank loans are measured by the S&P/LSTA Leveraged Loan Index, which represents bank loans issued to leveraged companies. Indexes are unmanaged and do not reflect any fees or expenses, and you cannot invest directly in an index. Past performance is not indicative of future results, and results may differ over other performance periods.
Strategies that use leverage extensively to gain exposure to various markets may not be suitable for all investors. Any use of leverage exposes the strategy to risk of loss. In some cases, the risk may be substantial.
