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Leverage, Risk, and Return in Europe: An Analysis of the Last 20 Years

Risk, Performance, and Reporting

By Vito Manciaracina  |  April 8, 2021

Years of low rates and ultra-accommodative monetary policy have made debt a cheap and easy-to-refinance source of capital. In Europe this came in the form of unconventional monetary policy tools used by the European Central Bank (ECB) in its attempt to fight economic crises and fulfill its mandate of price stability across the monetary union. However, inflation has never really been impacted, despite the huge efforts of the ECB, and we saw negative yields to maturity for the first time ever.

Euro 10 Years Yield to Maturity

Not surprisingly, companies responded to the sustained low interest rate environment by taking on more debt. Did greater leverage bring with it greater risk for investors? If so, were investors compensated for that risk? I analyzed the data over the last 20 years to find out.

Corporate Bond Yields Plummet

In September 2008, when on the opposite side of the Atlantic Ocean Lehman Brothers was declaring bankruptcy, European companies’ top-rated corporate bonds granted almost 5.8% of yield to maturity, BBB-rated bonds were giving almost 8.5%, and the yield equity investors required was at around 7.7%[1]. From that moment on bond rates began their decline, reaching all-time lows of -0.15% for AAA and 0.57% for BBB in December 2020 while the rate of return required by equity investors after the sharp decline in 2009 began a growth trend.

Euro Corporate YTM

European Companies Required Rate of Return

Capital Structure Changes

In this environment, after a deleveraging period that ended in 2011, the capital structure of the companies of the old continent began to change again, returning to the levels of 2009 exactly 10 years later and reaching new peaks in 2020 with the COVID-19 pandemic. For the first time since 2009, we recorded a debt/equity ratio of 100% during the summer of 2020; at the end of the year, this ratio stood at around 111%.

European Companies Leverage

Is Leverage Correlated with Risk?

Looking at the historical relationship between leverage, risk, and return, I wanted to know whether a higher level of leverage is correlated with higher levels of risk, and if so, is this extra risk rewarded with higher returns in the long run?

To answer this question, I used the annualized standard deviation of return as my risk metric and three ratios to assess the leverage of companies: debt/equity, debt/assets, and debt/EBITDA. My universe of companies was the constituents of the FactSet Market Indices Europe index (id: FR0000R3). To remove sector bias, I grouped my companies by RBICS sectors, created quintiles within each sector group based on key leverage ratios, and then combined the companies according to their quintiles.

Two out of the three sector-neutral ratios analyzed show that annualized standard deviation over the past 20 years has been higher for more leveraged companies across Europe. This indicates that investors in those companies have indeed borne a higher level of risk.

SD Last 20 Years for Key Leverage Ratios

A Closer Look at Risk-Adjusted Performance

Have investors been rewarded for bearing this higher level of risk? If higher volatility is tied to higher returns, depending on their degree of risk aversion, investors are still happy to bear it, but this was not the case. With respect to leverage, the higher standard deviation has not brought higher annualized returns over the past two decades resulting in both an absolute and risk-adjusted underperformance of higher leveraged companies with respect to low leveraged ones.

Annualized Returns Last 20 Years for Key Leverage Ratios

Sharpe Ratio Last 20 Years for Key Leverage Ratios

We can further analyze our three ratios at a sector level to learn more about the relationship between leverage and risk-adjusted performance at this level. The data shows that across all three ratios, in general companies with the lowest leverage outperformed high-leverage companies. However, this was not the case for the Utilities and Healthcare sectors, where companies with the highest leverage outperformed low leveraged ones. This illustrates that debt is not always bad and investors should consider the peculiarities of each sector rather than applying one-size-fits-all rules. On a risk-adjusted basis, the low leverage Consumer Non-Cyclicals sector is the best performer across all three ratios followed by Consumer Services.

Sharpe Ratio Debt to Assets

Sharpe Ratio Debt to EBITDA

Sharpe Ratio Debt to Equity

Conclusion

While we know that past returns are not indicative of future ones, our analysis shows that greater leverage has been correlated with higher levels of risk over the last 20 years; however, this elevated risk has not been rewarded with higher rates of return. We have never seen levels of leverage in Europe comparable to what we see today. This may be an indication of a paradigm shift in the financial markets or the simple consequence of rates that have never been so low, or both. Clearly investors should be aware of the leverage of companies in which they invest, especially during this period of unprecedented high leverage.

Valerio Posillico also contributed to this article.

[1] Aswath Damodaran, September 2008, Equity Risk Premiums (ERP): Determinants, Estimation and Implications, http://people.stern.nyu.edu/adamodar/pdfiles/papers/ERPfull.pdf, Value of Equity equation on page 52.

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Vito Manciaracina

Client Support Specialist, EMEA Analytics

Mr. Vito Manciaracina is a client support specialist for EMEA Analytics, based in Milan, Italy. In this role, he supports clients on FactSet’s analytics products with special focus on performance, risk, and quant solutions. Prior, he worked as a risk management junior consultant at Prometeia and completed an internship at MPS Capital Services as a credit trader. Mr. Manciaracina graduated with honors from the University of Siena with an MS in Finance.

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