Recent research conducted by Bank of America’s strategy team sheds light on a crucial concern for small-cap companies that appears to be unsettling investors: debt.
As the Federal Reserve has aggressively raised interest rates at an unprecedented pace, worries have emerged about how both corporations and consumers will transition from the low-interest rate environment of the 2010s to one characterized by significantly higher capital costs.
The Bank of America chart underscores that Russell 2000 companies are particularly vulnerable due to their substantial proportion of long-term debt maturing in the near term. This means they will face higher interest rates if they require additional capital to sustain their operations. Such an increase in costs is likely to reduce company profits and have an adverse impact on earnings.
Bank of America’s equity strategy team noted in a research report on Wednesday, “Despite the fastest hiking cycle in 40+ years, we believe the impact on S&P 500 earnings will be manageable. The real risk is in the Russell 2000.”
Given the Federal Reserve’s probable commitment to maintaining higher interest rates for an extended period beyond initial expectations, the issue of maturing debt could linger as a concern for small-cap firms.
Ed Clissold, Chief US Strategist at Ned Davis Research, pointed out in a research note on September 21 that “unless interest rates reverse lower, interest expense should continue to eat into small-caps’ earnings. Lower expected earning growth for small-caps is one of the reasons we favor large-caps over small-caps.”
It’s worth noting that not all companies are equally affected by the prevailing higher interest rate environment.
The Federal Reserve’s rate hikes have caused interest expenses for S&P 500 companies to surge. In the second quarter, expenses rose by 64.3% to $37.21 per share, reaching their highest levels since the second quarter of 2008. However, non-operating income, which includes income generated from interest on cash balances, stood at $6.86, marking an almost 89% increase over the last four quarters. According to Ned Davis Research, the disparity between expenses and non-operating income remains below the levels observed during the 2000s.
Furthermore, large tech companies, often referred to as megacaps, are faring even better in this environment. Ned Davis Research discovered that over the past four quarters, companies like Meta (META), Microsoft (MSFT), Adobe (ADBE), and Nvidia (NVDA) have generated nearly $1 billion more in non-operating income than they have incurred in interest expenses.
