Life May Soon Get Easier for (Some) Biotech Stocks. Here's Why.

As shown by the industry-tracking SPDR S&P Biotech ETF 's (NYSEMKT: XBI) decline of 22% over the last three years, biotech stocks haven't performed well as a group in recent history. But this doesn't mean biotechs have been struggling to get their programs out of the clinic and onto the market any more than usual.

There's a different phenomenon at play here. And if macroeconomic forecasts are to be believed, conditions could soon improve and lift the shares of a subset of biotech businesses out of the doldrums, at least by a little. Here's what's likely to happen over the next couple of quarters, and why it supports an investment in biotech right now.

It may get cheaper to grow

Raising capital is a key concern for most businesses, but it's a particularly acute issue for biotechs approaching the commercialization of their first few products, and especially for those expecting to have substantial manufacturing expenses. Remember these two categories, as they're the groups that could soon pick up a new tailwind.

The norm is for these companies to issue stock, using an initial public offering (IPO) , to generate enough cash to fund at least the first phase or two of clinical trials for their most important pipeline programs. The majority of the money goes to research and development (R&D) , based on the idea that reporting successes in the clinic will pave the way for issuing further shares.

With that second tranche of money, the goal is usually to sustain the company until near the end of the clinical trial process for at least its flagship program. It's frequently necessary to issue more shares to raise more cash to reach that milestone.

But once commercialization is in sight, management has a choice to make: Dilute shareholders even more by issuing more shares, or take on debt. For businesses that already have products on the market, the choice is usually to take out a loan, as interest expenses on debt are tax-deductible, offsetting the need to pay taxes on any profits already generated.

Biotechs commercializing a first or second product, like those with big manufacturing footprints, also often opt for debt rather than issuing shares. This is because lenders have at least some confidence in getting their money back if things go south. A company's existing medicines typically provide some cash flow for repayment, and even in the event of bankruptcy, manufacturing equipment can often be resold at much of its original value.

As we all know, debt can have consequences, even if the tax shield is handy. If a biotech has no taxable income, there's nothing to offset the cost of interest payments . So unprofitable biotechs risk burning down their limited cash reserves faster when the interest rate on their debt is higher. And since unprofitable biotechs sometimes have zero revenue because they haven't commercialized anything yet, interest expenses can cause financial problems if there's a hiccup along the road to generating revenue -- and there often is.

Therefore, when the Federal Reserve started to hike interest rates throughout 2022 to control inflation, it made total sense that many biotech stocks declined. The interest costs they were likely to incur immediately before and immediately after commercializing new medicines rose, so projections for the value of the stocks adjusted downward.

Now, the picture is changing. While it's impossible to predict with confidence exactly what the Fed will do or when, the consensus forecasts of financial analysts on Wall Street suggest that the cost of borrowing money is going to drop at least a little over the next few quarters.

This implies that biotechs in the special zone of opportunity, like Viking Therapeutics (NASDAQ: VKTX) and Iovance Biotherapeutics (NASDAQ: IOVA) , should have a bit more capital on hand as they push toward getting their medicines either out the door or (in Iovance's case) into wider circulation. Whereas Viking is approaching its last set of clinical trials before its attempt at commercialization, Iovance is building out its cell therapy manufacturing capabilities in a major way -- and Viking will likely need to do that too, if regulators approve its medicine in the next couple of years.

And both companies have balance sheets without any notable amount of long-term debt, so the time is right for them to borrow.

There's another layer to this opportunity

In the event of a recession, biotechs benefiting from the Fed's rate cuts may prove to be resilient.

Their revenue is derived from collaborations with other biopharmas, or from sales of their drugs to healthcare systems, which are in turn propped up by the fact that many healthcare services are not optional spending for consumers. Furthermore, an economy in recession would prompt the Federal Reserve to slash rates to lower levels, driving down the cost of borrowing even more.

So what's an investor to do with all this information?

One smart move would be to pay attention to businesses in that phase of maturity discussed earlier, and consider an investment in the near term. The rate those companies pay on their debt will probably not be a make-or-break factor, but it could support higher valuations -- and provide your portfolio with some protection against a recession-driven drawdown.

Alex Carchidi has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Iovance Biotherapeutics and SPDR Series Trust-SPDR S&P Biotech ETF. The Motley Fool has a disclosure policy .