Is a Debt Bomb Ticking?

If debt lights the fire of every financial crisis, as author Andrew Ross Sorkin once observed, then we may have a problem brewing. Companies have loaded up on a record amount of debt in recent years, thanks in part to rock-bottom interest rates. Most market watchers don’t expect the buildup to trigger an imminent credit disaster. Still, investors should be aware of risks that are building and choose carefully as they invest in bonds or stocks.

Bond investors

Build a core. A well-balanced portfolio needs a core bond fund for ballast. A true core bond fund holds mostly A-rated debt and no more than 5% of assets in high-yield bonds. The managers at Baird Aggregate Bond Fund (symbol BAGSX, expense ratio 0.55%) buy only investment-grade bonds. More than half of the fund’s assets sit in triple-A-rated debt, including Treasuries and government-backed mortgage securities. The rest of the fund’s holdings include high-quality corporate debt (40%) and other asset-backed securities (8%). The fund yields 2.09%, which may not impress income seekers, but its main role is to hold up in hard times. Consider it an insurance policy against a recession.

Beef up your safe havens with other government bonds. Agency mortgage-backed securities come with the same guarantee of Treasuries and a touch more yield. Stable interest rates should keep prepayments—a risk with mortgage debt—at bay. Vanguard Mortgage-Backed Securities comes in an exchange-traded-fund share class (VMBS, 0.05%, share price $53) and a mutual fund class (VMBSX, 0.07%). Both hold only triple-A-rated mortgage bonds. The ETF yields 2.55%, and the mutual fund yields 2.53%, a tad more than the typical core bond fund.

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Move up in corporate quality. Everything worked in fixed-income markets last year. Take some profits in junkier debt and bolster your exposure to higher-quality bonds. IShares AAA-A Rated Corporate Bond ETF (QLTA, 0.15%, $55) offers exposure to the highest-rated corporate IOUs and yields 2.42%.

Try emerging-markets bonds for extra income. This isn’t the risky sector it once was. Today, more than half of the emerging-markets bond universe is investment grade. The dollar isn’t as strong as it was in late 2017 and early 2018. In fact, it was relatively stable in 2019 against a basket of foreign currencies. And many analysts expect it to weaken this year. “Dollar weakness is positive for EM assets because governments and companies have a lot of dollar-denominated debt. When the dollar rises, it’s like a tax,” says Alec Young, FTSE Russell’s managing director of global markets research. And when it weakens, it’s like a rebate.

See Also: Contrarian Funds: Charting Their Own Path

Be prepared for volatility. The ride with emerging-markets bonds is twice as bumpy as the typical core bond fund. But securities in this sector, on average, yield twice as much. iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB, 0.39%, $115) yields 4.31%. This ETF sidesteps the impact of currency swings by buying dollar-denominated bonds. For a boost in income, you could pair your dollar-based ETF with the version that invests in IOUs in local currencies, iShares J.P. Morgan EM Local Currency Bond ETF (LEMB, 0.30%, $44), which yields 5.50%.

Stock investors

See what supports your dividends. Avoid companies with a lot of debt. Pro­fessional stock (and bond) pickers scrutinize balance sheets and income statements to get a sense of whether a company has the wherewithal to pay its debts—because if it comes to a choice between making a debt payment or paying a dividend, the former will always win. “Understanding what a company intends to do with its debt and how it intends to pay it down is paramount to what we do,” says Capital Group’s David Bradin, an investment specialist at American Funds.

Consider two auto­makers, Ford Motor and Daimler AG. Both offer similar dividend yields: Ford, 6.37%; Daimler, 6.46%. But Ford has a triple-B credit rating and Daimler is rated single-A. Moreover, Daimler generates enough in annual operating income to pay its yearly interest expenses 13 times over. Ford throws off enough to pay three years’ worth of interest payments. “Investors can jump to a conclusion that two companies in a similar industry with similar yields are the same,” says Capital Group’s Hanks. “But one has more risk than the other, and its dividend could get cut. You might want to ask yourself, Am I getting paid for the risk I’m taking?”

Choose a dividend pro. At Vanguard Equity-Income (VEIPX, 0.27%), two firms run the fund but work separately, homing in on large, high-quality firms with above-average yields. The fund yields 2.70%. Schwab U.S. Dividend Equity ETF (SCHD, 0.06%, $58) isn’t actively managed, but the companies in the index it tracks must meet several criteria. Firms must have paid dividends for at least 10 consecutive years, for starters. And only firms with the best relative financial strength, marked by their ratio of cash flow to total debt and their return on equity (a profitability measure), make the final cut. The ETF yields 3.11%. Vanguard Dividend Growth (VDIGX, 0.22%) yields just 1.84%, but manager Donald Kilbride focuses on cash-rich, low-debt firms that can hike dividends over time. Morningstar analyst Alec Lucas says the fund is “a standout when markets tremble.”

Add a dash of high quality. A strong balance sheet—one that’s low in debt—is a key characteristic of a high-quality company. It’s right up there with smart executives at the helm and a solid business niche in its industry.

Double down on high quality with iShares Edge MSCI USA Quality Factor ETF (QUAL, 0.15%, $101). The ETF invests in a diversified group of 125 large and midsize firms that have low debt, stable annual earnings growth and high return on equity. Johnson & Johnson, Pepsico and Facebook are among its top holdings. BlackRock has an international-stock version of this ETF, iShares Edge MSCI International Quality Factor ETF (IQLT, 0.30%, $32), that held up better than the MSCI ACWI ex USA Foreign-Stock index during the 2018 correction. The ETF yields 2.31%, and top holdings include Nestlé and drug company Roche Holding.

Go abroad. Companies in the rest of the world are less indebted, on average, than firms in the U.S. Even better, if you focus on the best players overseas, you might beat the U.S. stock market, says Capital Group’s Robert Lovelace. “A majority of the best-performing stocks over the past 10 years were companies based outside the U.S.”

At Fidelity International Growth (FIGFX, 0.99%), manager Jed Weiss focuses on firms with a competitive edge. If a company can raise prices for its goods without a drop-off in demand, Weiss is happy. That’s a trait that can buoy a business in rough times.

WisdomTree Global ex-U.S. Quality Dividend Growth (DNL, 0.58%, $66) invests in 300 dividend-paying companies in developed and emerging foreign countries. The fund yields 2.6%. The firms must meet certain quality and growth bars, including return on equity and return on assets (another profitability measure), to be included in the fund. As a result, the portfolio has an average debt-to-capital ratio of 29—less than the 34 ratio of the MSCI ACWI ex USA index (and 44 for the S&P 500). The U.K., Japan and Denmark are its biggest country bets.

See Also: Remembering One of the Great Debt Fighters