Lower debt = Less risk? Here’s why that’s not always the case…

From the desk of Miles Everson: I hope your week is going well! Every Wednesday, I talk about investing in the hopes of helping you attain financial freedom by boosting your investment portfolio. Today, let’s talk about credit health and how it can impact lending. Continue reading below to know why.

Lower debt = Less risk? Here’s why that’s not always the case… Picture this: Two men walk into a bank to get a USD 1 million loan. One is a successful businessman with USD 10 million in cash and has multiple investments under his belt, but with USD 20 million in debt with the same bank. The other man is a hardworking Amazon worker with zero debt and has USD 50,000 in savings. Who do you think is more likely to get that loan? If you guessed the businessman, then you’re absolutely right. … but why? You see, the bank knows the businessman well and it sees his USD 10 million in liquid assets and figures his business must be doing all right to manage a USD 20 million debt load. In this situation, the extra million dollars is just 5% more debt. As for the Amazon worker, the bank doesn’t have much to go on. A loan of a million dollars would be a huge leap from what that person is used to handling. While the scenario above seems counterintuitive at first, you can see this play out countless times in corporate America, as big companies with lots of debt often get better treatment than small ones. To understand why, we need to dig a little deeper… Smaller Equals Better? Smaller companies might have an edge in debt management and asset liquidation, giving them higher recovery rates than larger businesses. However, does this mean that a smaller company with lesser debt is better than a big one with lots of financial obligations? Not really. You see, when lenders take a look at a company, they don’t just pay attention to current debt or assets. They also look at a business’ history of managing debt, liquid assets, and what the market thinks of its ability to keep its lights on and doors open. One of the ways you can understand a company’s credit health is by looking at its credit default swap (CDS) spread. A CDS is a type of financial derivative that allows an investor to offset credit risk with another investor. It provides insurance against the risk of a default by a particular company or by companies of different sizes. The price of a CDS is also called the spread. Let’s go back to our example earlier… Like the businessman with USD 10 million in cash, big companies often have a proven ability to finance debt. They also typically possess stronger defenses against market shifts as they might possess a wider customer base or a more diverse product line. Smaller companies, on the other hand, tend to have higher CDS spreads. A higher spread means a lender is less willing to lend money to a business because higher spreads are considered riskier. For businesses with market caps of more than USD 50 million, CDS costs are less than 100 basis points (bps) per year… or 1% of the price of the loan. Meanwhile, companies with market caps below USD 1 billion cost more than 400 bps (4%) per year to insure… and the smallest companies—those worth less than USD 500 million—cost investors more than 700 bps (7%) per year. To sum up, CDS spreads are a risk assessment tool based on track record and scale. So when smaller companies have higher spreads, it is the market’s way of saying that it hasn’t seen enough from them. Investors just don’t trust that smaller companies can handle debts that punch above their weight class. Bigger is Often Better in the World of Credit Lenders tend to favor bigger companies over small ones because they tend to have a history of managing big amounts of debt. However, this doesn’t mean that big businesses are too big to fail or small ones are always risky. So, when it comes to assessing the credit risks of the stocks and bonds you own, don’t always assume a company with less debt is automatically safer. 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