Risky Debt and Beta: Why Proportionality Fails

Imagine a company like a seesaw. On one side, we have the company’s assets – everything it owns and uses to make money, like factories, equipment, and even its brand reputation. On the other side, we have how those assets are financed. This financing is split between equity, which is like the owners’ stake, and debt, which is borrowed money. Beta is a measure of how much a company’s stock price tends to move up or down compared to the overall market. Think of it as a measure of a stock’s volatility relative to the market’s volatility. A beta of 1 means the stock price tends to move in the same direction and magnitude as the market. A beta greater than 1 suggests the stock is more volatile than the market, and a beta less than 1 indicates it’s less volatile.

Now, let’s talk about leverage. Leverage is essentially the extent to which a company uses debt to finance its assets. The debt-to-equity ratio is a common way to measure leverage. It’s calculated by dividing a company’s total debt by its total equity. A higher debt-to-equity ratio means the company is using more debt relative to equity.

In a simplified world where debt is considered completely safe, meaning there’s virtually no chance the company will default on its loans, we would expect a pretty straightforward relationship between leverage and equity beta. As a company takes on more debt, its equity becomes riskier, and therefore its equity beta tends to increase. Why? Because debt creates a financial obligation. The company must make fixed interest payments regardless of its performance. This fixed obligation amplifies the fluctuations in returns for equity holders. Think of it like this: if a company has no debt and its business performance varies, the owners, the equity holders, experience those variations directly. But if the company has debt, a portion of the company’s earnings must first go to debt holders before anything is left for the equity holders. This means that any ups and downs in the company’s earnings are magnified for the equity holders after paying the debt obligations. This magnification effect makes the equity riskier and pushes up its beta. In this idealized scenario with risk-free debt, we might expect equity beta to increase roughly proportionally to the increase in leverage, at least within a certain range.

However, the real world is not so simple. Debt is rarely truly risk-free, especially for companies. As a company takes on more and more debt, the probability that it might struggle to repay those debts increases. This is when debt becomes ‘risky’. When a company’s debt becomes risky, something interesting happens to the relationship between leverage and equity beta. The equity beta still increases with leverage, but it no longer increases in direct proportion. The increase in equity beta becomes less pronounced than we would expect based solely on the increase in the debt-to-equity ratio.

The reason for this dampened increase is that some of the company’s risk is now being transferred to the debt holders themselves. When debt is risky, it means there’s a chance the company might default, and debt holders might not get back the full amount they are owed. Because of this default risk, the debt itself becomes more sensitive to the company’s underlying business performance. In good times, the debt is likely to be repaid, and it behaves more like risk-free debt. But in bad times, the value of the debt can fall significantly as the risk of default increases.

So, when debt is risky, it starts to behave more like a hybrid between pure debt and equity. It shares some of the characteristics of equity in that its value becomes sensitive to the company’s fortunes. Because the debt holders are now bearing some of the company’s overall risk, the equity holders are not bearing the full brunt of the increased financial risk from leverage. The increase in risk associated with higher leverage is now split between both the equity and the debt.

Therefore, the equity beta still increases as leverage increases, reflecting the increased financial risk. But because the risky debt itself now carries some of the firm’s business risk, the equity beta does not increase in a purely proportional manner to the debt-to-equity ratio. The relationship becomes more complex, and the increase in equity beta for each additional unit of leverage becomes smaller as the debt risk rises. The risky debt acts as a kind of buffer, absorbing some of the volatility that would otherwise be fully reflected in the equity’s beta if the debt were risk-free.