Bad debt is money that creditors (lenders) have to write off when people can’t repay their loans or pay their bills on time. When the economy is struggling, there’s usually an increase in people unable to pay what they owe.
The FTSE 100 has lots of exposure to bad debt. Some of the biggest companies that make up the index rely on loan payments and bills being settled. But what does this mean for investors in these companies during the cost-of-living crisis?
This article isn’t personal advice, if you’re not sure if an investment’s right for you, seek advice. All investments fall as well as rise in value, so you could get back less than you invest.
Banks are used to this cycle
Banks are one of the FTSE 100’s biggest sectors. Names like HSBC, Lloyds Banking Group, NatWest, Barclays and Standard Chartered all sit in the index. As an idea of how important banks are to investors, they make up about a third of the entire market value of European listed companies.
Bad debt affects banks in the form of impairment charges and write offs. These are recognised when a bank thinks a higher number of customers are going to be unable to pay their loans and mortgages.
Barclays recognised a £1.2bn impairment charge for last year as it prepared for the effects of a weakening economy. Lloyds Banking Group set aside £1.5bn. There’s no denying these sums are huge, but the reality is they don’t tend to affect the investment stories too much.
Banks are cyclical. Their fortunes ebb and flow with the wider economy. If the economy holds up better than planned, banks can release some of their impairment charges. That boosts profits and is something we saw after lockdowns when some banks were over cautious in their outlook.
At the same time, bank balance sheets are in remarkable health, putting them in a strong position to weather ups and downs.
Energy companies – finances aren’t the problem
Companies like British Gas owner, Centrica, are clearly right in the line of fire when it comes to weakening consumer paying power. Gas bills have gone through the roof. Centrica has put £75m aside to help its worst affected customers in the British Gas Energy business. This has tanked divisional profits, but the group is being propped up by gains elsewhere.
It would be wrong to suggest bad debt isn’t a risk. The group has said that a higher number of new customers are going into debt, and direct debit cancellations are deteriorating. As it stands, Centrica’s recently upped its impairment charge by £213m to cover the weakening environment, but this could get worse before it gets better.
Centrica’s balance sheet is very healthy. It has more cash than debt, leaving it with a net cash position. However, this is an important risk to monitor.
A bigger concern with energy utilities is reputational. The cost-of-living crisis has seen living conditions deteriorate for millions of people. Energy companies are receiving a sharp backlash and are coming under increased scrutiny. Being under a political spotlight is never easy and increases the risks of heat being taken out of Centrica’s valuation in the short term.
Some key investor takeaways
Bad debt is an unavoidable symptom of a weakening economy. Because of the makeup of the UK market, many companies have exposure to increased bad debt, which can hurt profits and dent investor sentiment in the short term.
Just because a company can be affected by bad debt doesn’t mean they should be discounted as an investment option. But if you choose to invest in a company that relies on people paying bills, it’s crucial to make sure the business is in reasonable financial health.
This means they’re more likely to stomach ups and downs in the economy. Mainstream, larger lenders and/or energy companies are more likely to fall into this category than smaller companies.
Remember, investing in individual companies isn’t right for everyone. That’s because it’s higher risk, your investment depends on the fate of that company. If that company fails, you risk losing your whole investment. If you cannot afford to lose your investment, investing in a single company might not be right for you. You should make sure you understand the companies you’re investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.
Unless otherwise stated estimates are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.
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