Bad Credit? No Problem.

Share prices of companies with the weakest balance sheets have increased 94 percent in just over two years; junk bond issuers rising faster than the overall market.

In the U.S. equity market, the worse a company’s finances, the better it’s doing.

Stocks with the weakest balance sheets have climbed more than 8 percent in 2014 and 94 percent since the end of 2011, generating almost twice the gain in the Standard & Poor’s 500 Index over that period, according to data compiled by Bloomberg and Goldman Sachs Group Inc. Shares in the category this year are beating those that most investors consider the bull market’s leaders, such as small caps and biotechnology, which tumbled in March.

Gains are being sustained by speculation that the corporations whose finances put them most at risk will thrive as the economy improves. Helped by rising bond issuance and falling defaults, stocks from Tenet Healthcare Corp. to Frontier Communications Corp. are advancing even as Federal Reserve policy makers take steps to end unprecedented economic stimulus.

“Having a weaker balance sheet isn’t a liability or a drag on potential company performance at this point,” David Kostin, chief U.S. equity strategist at New York-based Goldman Sachs, said in a May 20 phone interview. “In an economy that’s getting better, you can operate perfectly fine with a little more leverage.”

A basket of 50 companies that rank lowest in measures comparing equity to total liabilities and earnings to assets, compiled in a gauge known as the Altman Z-Score, has increased 8.3 percent in 2014 after climbing 50 percent last year. The highest-rated group is up 3 percent since December after rallying 28 percent in 2013, according to data compiled by Goldman Sachs.

Shares with weaker finances have benefited as the Federal Reserve held interest rates near zero for the past six years and bought $3.6 trillion of bonds to stimulate the economy, spurring an unprecedented wave of debt financing. Companies in the S&P 500 that issued junk bonds—securities deemed the riskiest by credit raters—in the past year have seen their stocks climb 26 percent over that period, according to data compiled by Bloomberg. That compares with a one-year increase of 15 percent for the full S&P 500, which closed at a record on May 23.

The U.S. stocks gauge rose 0.5 percent to 1,909.12 at 9:45 a.m. in New York today.

Junk-rated borrowers from Oklahoma City-based Chesapeake Energy Corp. to Netflix Inc. in Los Gatos, California, issued a record $380 billion of speculative-grade bonds in the U.S. last year, data compiled by Bloomberg show. While the pace has slowed in 2014, a monthly average of $29.5 billion is still 13 percent higher than during the previous four years.

 

Insatiable Demand

“There’s insatiable demand for high-yielding, lower-quality instruments, and companies are taking advantage of that to get money,” John Carey, a Boston-based fund manager at Pioneer Investment Management Inc., which oversees $220 billion worldwide, said in a May 22 phone interview. “The market is rewarding the kind of short-term behavior and earnings enhancement that this kind of financial strategy can provide in a low-interest-rate environment.”

Better returns from companies with the weakest balance sheets are also being aided by a shift in investor demand for stocks trading at lower valuations. Equities in the Goldman Sachs basket with the lowest Altman Z-scores, such as Natick, Massachusetts-based Boston Scientific Corp. and Time Warner Inc. in New York have an average price-earnings ratio of 21. That compares with 31 for the Facebook Inc.-led strong balance sheet category.

“The more high-growth momentum names tend to be more expensive,” Joseph Tanious, a global market strategist at JPMorgan Asset Management, said in a May 21 phone interview. His firm oversees $1.6 trillion in client assets. “People are moving back into some of the more defensive names, and those stocks have performed well.”

Dallas-based Tenet Healthcare, a hospital operator rated B by S&P, has gained 14 percent this year. The company is getting a boost from Obamacare as fewer uninsured patients are visiting hospitals in states that have expanded Medicaid. Frontier Communications, based in Stamford, Connecticut, and rated BB-, has surged 25 percent this year, beating a group of phone companies that have increased 2.6 percent in 2014.

Investors will tire of value stocks and turn back to momentum-driven companies with higher potential for share appreciation, according to Jeff Mortimer of BNY Mellon Wealth Management.

Facebook, Alexion Pharmaceuticals Inc., and Michael Kors Holdings Ltd., companies in the stronger balance sheet basket that gained at least 41 percent in 2013, have an average 12-month price target 19 percent above their prices now, according to analyst estimates compiled by Bloomberg.

 

‘Head Fake’

The outperformance of weak balance sheet companies “may be a head fake,” Mortimer, the Boston-based director of investment strategy for BNY Mellon Wealth Management, which oversees about $185 billion, said in a May 21 phone interview. “We still believe that growth over time will dominate value at this part of the cycle.”

Tighter financial conditions are the “biggest risk to continued weak balance sheet outperformance,” according to Kostin of Goldman Sachs. Policy makers at the April 29-30 Federal Open Market Committee meeting reiterated that the central bank will keep the key interest-rate target at almost zero for a “considerable time” after concluding its monthly bond-buying program.

Fed Chair Janet Yellen suggested on March 19 that the central bank might raise U.S. interest rates by the middle of next year, six months after bond purchases end.

Relaxed lending standards have led to a reduction in corporate defaults. Eight U.S. companies failed to meet debt obligations through April 24, compared with 19 over the same period in 2013, according to an S&P Ratings Services report.

The Fed is “trying to allow otherwise shell-shocked or risk-avoidant investors to participate in this economic expansion,” Stephen Wood, the New York-based chief market strategist at Russell Investments, which oversees more than $259 billion, said in a May 21 phone interview. “We’re not approaching a credit-constrained environment, at least from a policy perspective.”

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