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Beware of stocks with high debt

Financial markets across the world have experienced the lowest interest rates the world has ever seen. Zero interest rates or even negative interest rates were introduced to try to stimulate economies.

This tactic arguably worked, or at least softened the blow of the GFC. However, low interest rates can’t stay low forever without having extremely damaging knock on effects with asset prices, risk and debt.

Low cost debt is arguably the main reason why asset prices across the world are trading at record highs.

Donald Trump winning the US election could change the game. He wants the Federal Reserve to increase interest rates back to more normal levels. The Fed chair, Janet Yellen, doesn’t want to do anything too drastic but accepts that rates do need to be higher and expects to raise the rate several times over the next few years.

This is important because a lot of our businesses have debt that is directly or indirectly related to the US interest rate. The big four banks such as Commonwealth Bank of Australia (ASX: CBA) have already passed on a number of small rises to loan holders in Australia.

Increasing interest rates in Australia could have a severe impact on heavily indebted businesses and households.

Businesses like G8 Education Ltd (ASX: GEM) and Sydney Airport Holdings Ltd (ASX: SYD) could see significant increases to their finance charges and potential decreases to their net profit.

This would be particularly painful for real estate investment trusts (REITs) who could see decreased profits on top of decreasing values for their properties. REITs like Westfield Corp Ltd (ASX: WFD), Scentre Group (ASX: SCG), Cromwell Group (ASX: CMW) and Goodman Group (ASX: GMG) could all face future profit and share price pressure.

The best businesses to own in a rising interest environment are ones that have little to no debt and don’t require debt for future growth. Companies like Altium Limited (ASX: ALU), REA Group Limited (ASX: REA) and Class Ltd (ASX: CL1) are all great examples of companies with strong balance sheets, but they don’t often trade cheaply.

Foolish takeaway

Taking on debt is always a risk for anyone or any business. Debt could become an increasing problem for some businesses in time so I think it’s worth considering how much of your wealth is tied up with investments that are reliant on debt.

To protect your portfolio from debt, you should consider filling your portfolio with great options like these.

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The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Sydney Airport Holdings Limited. Motley Fool contributor Tristan Harrison owns shares of Altium and Class Limited. The Motley Fool Australia owns shares of Altium and Class Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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