Mark LaMonica: So before we get started, we're going to do another plug for our conference coming up. So it's the 11th and 12th of October. All of that 3ill be streamed so anyone who doesn't live in NSW can of course attend, although you can travel to Sydney and see it.

Shani Jayamanne: For, the second day so the 12th of October.

LaMonica: Exactly that's the live day at the ICC, so if anyone wants to come meet Shani come to the conference.

Jayamanne: Or Mark.

LaMonica: Mostly you. And if anyone has any questions about the conference, you can send me an email. My email address is in the episode notes and there's a link in there I think as well.

Jayamanne: To register.

LaMonica: To register for the conference so we think it's a great day. Shani did a great day – a great job on the agenda. So, yeah, come hear some market insights from people at Morningstar and some great external speakers as well.

Join us in-person or digitally on 11-12 October at the Morningstar Investment Conference for Individual Investors. Click here to register today.

Jayamanne: Perfect.

LaMonica: All right,

Jayamanne: Good pitch.

LaMonica: Thank you. So let's get started. So today, Shani, we're going to talk about debt. So how do you feel about debt?

Jayamanne: I'm not really a big fan.

LaMonica: Yeah, I mean, I'm not a big fan either, but today we're going to talk about the implications of debt on investors. But first we need to do a little bit of foundational work around debt, because sometimes people forget about this.

Jayamanne: And all debt lowers future standards of living. It's a self-imposed tax on future earnings. And that's true for individuals, but it's also true for companies and it's true for governments.

LaMonica: So no matter what you need to start out thinking debt is a negative. And any time an individual, a company or a government decides to take on debt, it should be because something positive is supposed to come out of it. Right, it’s supposed to counteract the negative part of debt. So if an individual goes into debt, it should be because whatever the debt pays for – and it could be education that will result in higher future earnings, it could be for an asset like a house that you believe at some point is going to make a positive financial impact on your life. Whatever it is, you need to make sure that that positive, of course counteracts the negative of debt.

Jayamanne: A company should believe that what is being funded by the debt, perhaps a new project, is going to result in returns that exceed the cost of the debt, so shareholder value is created.

LaMonica: And debt can amplify return, so buying a house that appreciates in value will earn a higher return if it's funded by debt rather than just purchasing that house for cash. And same thing if debt is taken out to invest in the share market and it goes up in value.

Jayamanne: And this amplification of returns that debt provides can become addictive. Want a more expensive house? Take on more debt. Want to try and grow earnings faster? Take on more debt. Want to fund more infrastructure projects and create more jobs? Take on more debt.

LaMonica: And what fuels this addiction is low interest rates because low interest rates makes the hurdle rate for an investment lower. To make a positive impact on the future means earnings returns need to exceed the interest rate paid, so it's easier to exceed the cost of debt at an interest rate of 3% than at 6%.

Jayamanne: The other thing that feeds this addiction to debt is the availability of debt. Because you don't necessarily have to pay off debt, you can pay off old debt with new debt. So in theory, as long as you can continue to issue more debt, you will never default. And that ability to borrow in the future, especially if you can borrow cheaply, means you never have to make hard choices.

LaMonica: And those two conditions we just talked about as enablers for an addiction to debt were both in place for a long time. In reality, since interest rates started dropping in the 80s but of course this was turbocharged since the GFC, with a last bit of petrol thrown on the fire during COVID.

Jayamanne: And predictably, we borrowed and borrowed and borrowed. Individuals, companies and governments all kept borrowing. In 2022, total global debt hit $453 trillion, and that is hard to put into perspective but that is $56,000 for every man, woman and child on earth.

LaMonica: And we often measure debt as a percentage of GDP. In theory, if we are using debt productively and doing positive things with debt, the percentage of debt compared to GDP shouldn't be rising. But it has gone up. So global debt hit 349% of global GDP in 2022.

Jayamanne: Total government debt as a percentage of GDP increased 76% between 2007 and 2022. Non-financial corporate debt rose from 31% of GDP to 98% of GDP in that same time period. Consumer debt went up only 7% and is at 64% of GDP.

LaMonica: And in Australia, we've seen a huge increase in consumer debt. We can take mortgages for an example. In 1970, housing debt to GDP in Australia was around 10%. By 1990, it had increased modestly to around 15% of GDP. And then it accelerated rapidly. By the turn of the Millennium, it was around 40%. Today it's sitting above 90%, and the magnitude of debt is concentrated within a portion of homeowners as 31% of all houses in Australia are owned outright.

Jayamanne: So we've got a lot of debt as society and we talked earlier about how debt lowers future standards of living, but it also increases risk. It increases your personal financial risk just as it increases the risk on a company.

LaMonica: So the world, and that's individuals, companies and governments, are more risky than they were back in 2007, before this era of ultra-low interest rates and widespread availability of debt. And we’re about to find out how risky because interest rates have gone up dramatically and the availability of debt has dropped. That makes it harder to service the existing debt and makes it harder and more expensive to delay that day of reckoning by simply taking on more debt to pay off the old debt.

Jayamanne: And debt will have a profound impact on the overall economy and on the performance of individual companies, which of course both impact us as investors. And it's worth noting that the impact of higher interest rates on this pile of debt we've collectively amassed as a society is not immediate. It takes time.

LaMonica: So let's briefly start with the economy. And we can use 2 examples, although there are of course many. We can start with government debt and there's no better example than the US government. US government debt increased from 35% of GDP in 2007 to 93% of GDP currently. And 67% of the US government debt matures within five years. And TD Securities estimates that the US pays an average rate of 3.4%. Well current rates are higher than that, meaning that more money from the US government will not go to supporting the economy – it will go to paying off debt.

Jayamanne: And it also means that tax cuts are less likely and the options for fiscal stimulus are less likely, which means that there are less levies for the government to stimulate the economy. And there were some boosts to the economy that we saw with Trump's corporate tax cuts through the direct payments to US taxpayers during COVID and with Biden spending bills. And of course, inflation also in theory, limits things governments can do, but of course politicians tend to not take that into account when their political future is on the line.

LaMonica: The next big impact of debt is on consumer spending. Heavily indebted consumers are able to spend less if more of their salaries are going to pay off debt, and this is what we're seeing in Australia. As we mentioned earlier, there have been a huge jump in mortgage debt in Australia as a percentage of GDP. And as everyone knows, the increase in interest rates is directly impacting Australian consumers. In the past year, consumer spending has dropped in NSW and Victoria.

Jayamanne: And the fact that consumer spending is dropping, even as the population is growing, and inflation makes everything cost more, gives us a sense of how much how some households are hurting.

LaMonica: And what we've really seen with spending patterns is a bit of a bifurcation across generations. As we discussed, mortgage debt as a percentage of GDP, it has skyrocketed but at the same time, almost 1/3 of Australians have paid off their house. Those are generally older people who continue to spend on things like travel, but younger people have cut back on spending on everyday items.

Jayamanne: And obviously this is not exactly news to anyone that's paying attention, but with consumers and governments under a heavy debt burden, it's going to restrict growth rates in the economy going forward.

LaMonica: In Australia, 22% of GDP is government spending, and consumer spending makes up 48% of GDP.

Jayamanne: And we saw this impacting the intergenerational report released in late August. The report cited debt and forecast GDP growth of 2.2% for the next 40 years. That is 40% lower than the growth in GDP in Australia over the previous 40 years.

LaMonica: And this isn't a great environment for a company to operate in. Lower growth matters because it's a tailwind to company profits. But of course, companies have also taken on a lot of debt and are facing higher costs of debt going forward. So the first thing we to look at is zombie – so what do you think of zombie Shani?

Jayamanne: I can't say that I spend a lot of time thinking about zombies Mark.

LaMonica: Okay, well, these are not the zombies from movies. So we're talking about zombie companies here, and a zombie company is a company that doesn't generate enough cash to pay off the interest on the debt that is taken out. And this seems like an impossible situation, but these are the very companies that have used the widespread availability of debt to simply continue to roll over debt. In other words, they have used new debt to pay back old debt.

Jayamanne: And in theory there is a reason why a company would do this. A company may be borrowing money to invest in growth, which just hasn't materialised yet. That is the theory at least, they may not be able to cover their debt today, but hopefully future earnings would do that. But it assumes that the earnings would appear at some point.

LaMonica: But higher interest costs mean that even more growth is needed to get to that point. That is what we talked about earlier – when a company is borrowing at 3%, the return hurdle is lower than when a company is borrowing at 6%.

Jayamanne: And if we turn our attention to the US, we can see that even though the economy is still strong, there's low unemployment and a fair amount of growth. We still see a spike in default and bankruptcy filings by corporate America. Bankruptcy filings in the US are on track for the highest level this year since the GFC according to the AFR, and the GFC was of course a time when the economy was doing terribly. The fact that bankruptcy filings are up when the economy is strong doesn't bode well for the predicted slowdown of the economy.

LaMonica: And Columbia Capital keeps a zombie index, which tracks the proportion of companies that are in this situation where they don't earn enough cash to pay their interest. And using data from 2022, they estimate that 10 to 15% of companies in Australia, the US and Europe are now zombies.

Jayamanne: And this is up from an estimate of 4 to 5% a decade ago. And they point out that this is data from 2022, before the impact of interest rate increases had truly been felt. They say this is clearly a high proportion of companies that meet this zombie criteria.

LaMonica: Which certainly is not good news for investors. So we painted quite a picture, but the real question is, what can investors do?

Jayamanne: Well, the first thing an investor can do is pay attention to debt levels. We want to avoid these heavily indebted companies that will either not make it or will be so restricted by their debt burdens that they won't be able to invest to grow earnings.

LaMonica: And that brings us back to the balance sheet. So look at debt ratios. On the extreme side of things, look at things like the interest coverage ratio, which shows how much, if any, earnings cover interest payments. If it is negative, you are looking at a zombie, but even if the coverage ratio is positive, the margin matters because it shows if a company will be able to keep spending to grow the business, and if that coverage ratio may disappear as the impact of higher levels of interest rates work their way through the company's debt.

Jayamanne: And if you don't want to spend your time digging through a balance sheet, looking at total debt, you can let others do this screen for you – we've talked about the quality factor before. There are ETF such as the Vanek ETF with the ticker symbol, Q-U-A-L or QUAL, which has quality screens which include the financial condition of the company as a measure.

LaMonica: You can also look at our analyst assessment of the balance sheet, which is measured in the capital allocation rating, and this takes a bit of a mindset shift for many investors. We've been very focused on growth as investors and when debt is cheap and funding is readily available, it makes sense to focus on growth.

Jayamanne: But in this current environment, financial strength and financial flexibility is critical. And it's critical not just to find companies that aren't going to go under. It is also critical because a company with strong finances should be able to take advantage of an environment where desperate companies are going out of business or are forced to sell off assets to simply stay in business.

LaMonica: And we can look at commercial property as an example. This is a sector that on the surface is in a lot of trouble. Money was borrowed cheaply to purchase assets like buildings. But as debt costs have gone up, the yield that they're earning on that debt through rent has all of a sudden disappeared. That is because of higher interest rates, but also because of issues like low occupancy.

Jayamanne: And a lot of these owners of commercial property are in trouble as the value of the buildings go down as higher interest rates have dropped valuation levels. This is where we can see a drop in net tangible assets or NTA, which is the value of buildings going down as the debt levels of the assets go up. Many companies have been slow to mark the value of their buildings to market and don't want to sell because lower prices will indicate how much asset values have fallen.

LaMonica: This means that once that forced selling happens and some of it will be forced because the cash flow issues and debt covenants that govern ratios of debt to assets, there will be bargains out there if there's enough financial flexibility to take advantage of them.

Jayamanne: So this all sounds very scary, Mark, and I'm sure a lot of investors are thinking perhaps it's time to sit this thing out as we start to see increases of interest rates work their way through the economy.

LaMonica: I'm sure that is a reaction, but it's also important to remember that things can always seem scary. There are great companies out there that will use this period as an opportunity to grow and pick up cheap assets. But more than anything, this is a reminder that fundamentals matter. Companies that have discipline in borrowing, low debt levels and prudent investment approaches are always investors best friends. Even during crazy periods like what we've just experienced when it seems that debt fuelled growth are all that matters, quality always matters, even if there are periods that it's a bit of an anomaly when it seems boring and underperforms.

Jayamanne: And it's important to remember that the period from the GFC through COVID was not a normal economic period. The level of interest rates was historically low and the traditional relationship between low interest rates and inflation was temporarily severed. We are getting back to normal interest rate environment now and governments, companies and consumers who took on too much debt are in trouble. But not everyone did that. As investors, we need to fund companies that did not succumb to the addiction of debt.

LaMonica: All right. So that's our debt podcast in Zombie podcast. Hopefully there'll be no zombies at our conference, but the only way to know that is if you come yourself and buy a ticket and find out. So we hope to all see you there on October 12th in Sydney.