Thursday, 16th April 2020 By Pascal Vilhelmsson
The Walking Debt
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The Rise of Zombie Companies and the Impact of COVID-19

Difficult… an apt term to describe how the start of 2020 has been so far.  It has been difficult for individuals, countries and companies alike, the spread of COVID-19 has affected life as we know it on multiple levels. Over 2 million people have contracted coronavirus, of which many are unfortunately no longer with us, people have lost their jobs, companies have gone bankrupt and the economic landscape around the world has changed drastically. This article serves to provide insight into the latter and discuss how credit markets have reacted, how this will contribute to the further rise of Zombie Companies (companies that earn too little to make interest and debt payments), and the near-term outlook.

Diverse market reactions

The impact of coronavirus has been felt across financial markets, with the situation only being compounded by the recent oil price war. Issues have arisen in both equities and credit markets. Bid-ask spreads for equities have widened and liquidity in bond markets has suffered tremendously. The investment grade environment still has some liquidity, albeit limited, with high yield completely drying up. Investors are stuck in a difficult situation with little they can do. Corporate bond markets have felt the brunt of the force compared to government bonds. In fact, German 10y government bond yields have decreased by 16bps year to date (YTD), while EUR non-financial corporate bond spreads (risk premium of a corporate bond against the risk-free rate) at their peak increased by more than triple and currently stand at around an increase of 2.5x YTD . The US has experienced the same trend, with USD non-financial corporate bond spreads also tripling at their peak and currently stand at over 2x YTD, while the US 10y government bond yield has decreased by an astonishing 116 bps during the same period. The diverse reactions of government and corporate markets can be puzzling at first sight, but the recent government initiatives to curb the impact of coronavirus can explain this disparity. The ECB announced a €750bn bond-buying program and the US fed announced that it will continue Quantitative Easing (QE) until “infinity”. Even the highly affected country of Italy has only seen a small shift in 10y government bond yield with a 40bps increase YTD, with the current yield being well below that of 2018 and 2019. This lack of reaction in Italian government bonds can be attributed to two factors. Firstly, the economic situation pre-crisis was not great to begin with, and secondly investor confidence is high that the ECB will bail out any poor performing EU countries. The politically driven confidence is mirrored in the BBB- rating of Italy. Although the underlying figures would classify Italy into the junk territory, the power of the ECB negates this. 

To provide context about the credit markets, we are currently at record levels of both corporate and sovereign debt, even higher than the debt levels during the 2008 financial crisis. To shed some light on the size of this debt, the level of corporate debt in the United States amounts to 75% of the GDP, with industries directly impacted by the coronavirus such as automotive, transportation and hospitality having dangerously high levels of debt. At Scorable we calculate the 12-month probability of credit rating downgrade of companies using artificial intelligence (AI) on both quantitative and textual data. From our AI models we can see that 85% of companies in the automotive industry are in the highest two risk classes (higher than 20% probability of downgrade), 90% of hospitality companies are in the highest two risk classes, and 72% of transportation services being in the highest risk classes (note: these percentages are based on the current corporate bond issuer universe of Scorable). These insights alongside March having the fastest historic pace of downgrades of corporate bonds on record back to 2002, shows that we are in a tumultuous time. These alone are scary indicators, but if we combine this with the recent rise of zombie companies we may just be at the start.

The rise of zombie companies

A zombie company is one who is at least 10 years old and has had an interest coverage ratio of less than one for at least 3 consecutive years as defined by Adalet McGowan et al (2017). Or in other words, zombie companies are ones that earn too little to make interest payments on their debts, and only survive by issuing new debt. Zombies currently account for 12% of publicly traded companies worldwide according to the Bank for International Settlements (The bank for central banks). The share of zombie companies by region varies with 10% in Europe and a whopping 16% in the US. These are staggering rates when compared with the global average of just 2% in 1990. 

What has led to this rise in the number of zombie companies? The increase in share of zombie companies follows (well inversely) the trend of decreasing interest rates. In theory, lower interest rates should make it easier for companies to make interest payments and pay off their debts. However, in practice this has not been the case; as interest rates fell it became cheaper for companies to issue debt. So, the decrease of interest rates did the exact opposite and promoted increased debt. This lax financial environment made it increasingly easy for zombie companies to appear, they did not have to worry about earning enough to make interest payments, as they could just issue new debt to cover those costs. At the same time, in such a low interest rate environment, investors increasingly looked towards riskier debt for higher return. 

The prevalence of zombie companies is especially high in industries that rely heavily on external funding such as commodity industries like oil & gas, metals & mining, and coal. If we again look at those industries using Scorable insights, we see that 66% of those industries are classified in the two highest risk categories. This is where the drastic drop in oil prices adds fuel to the fire, for many companies the current oil price has fallen below the threshold to meet their debt and interest payments. This brings us to the point that the previously mentioned industries heavily impacted by coronavirus (Auto, Hospitality and Transport) alongside those impacted by the oil price drop are likely to get infected and join the ranks of zombie companies. This is not limited to the directly affected industries but could have a widespread increase across industries.

Government initiatives

As previously mentioned, the ECB launched a €750bn bond-buying initiative that can and will help alleviate economic pressures exerted by the coronavirus, but this does not come without limitations. Similar to what happened in practice with decreasing interest rates the ECB bond purchasing will further incentivize companies to issue more debt as they are “guaranteed” to be purchased, likely converting more companies to zombies. This does not stop here, the announced ECB program will not purchase any bonds below BBB rating. This is particularly worrisome as 53.8% of corporate bonds are rated triple-B, meaning that if the current record pace of downgrades continues many of these issuers will fall below the threshold set by the ECB. To compound this, many institutional funds have limitations set on how many, if any, high yield (rated below BBB) bonds they can hold. So, they will have to sell those bonds if they are downgraded, but the current illiquid state of the high yield market will make this difficult. 

These issues are not only limited to the euro zone but are mirrored by the US fed’s recent announcement that it will also start purchasing corporate bonds. However, the US fed is taking a different approach with their announcement that they will extend their bond buying program to recent fallen angels (bonds that have been downgraded from investment grade to high yield).  According to Bloomberg, "The central bank will now buy the debt of companies that were investment-grade rated as of March 22 and subsequently downgraded to no lower than BB-, or three levels into high-yield”. This will likely reduce the rate at which US zombie companies default on their debt as funding for recent investment grade bonds will remain, however like the ECB’s program this will not provide any liquidity to the existing high yield market. 

Outlook

Fitch Ratings have revised their default rate forecasts drastically for 2020 and indicate an even larger jump in 2021. The US high yield bond default rate forecast for 2020 has been revised from 3.5% to 6% with EU default rate forecasts up to 5% from 2.5%. The forecasted default rate for 2021 by Fitch is 8% for both. The incentivization of issuing more debt due to the government initiatives and the lack of liquidity for high yield bonds will push the percentage of publicly listed zombies well past the 12% global average. 

Can this zombie crisis have the same domino effect and start a wave of defaults like the subprime mortgage crisis like in the 2008 crisis? That is a difficult question to answer, and I don’t know the answer, but the longer the coronavirus continues to spread at its current pace and affect the economies of countries worldwide, the higher the likelihood that zombies with no access to liquidity will die. Central bank programs like the one from the ECB and the US Fed are also bound to end at some point, and if these buying programs included zombie companies the consequences can be dire. Once zombies default on their debt a second wave of market depression will start and affect wider financial markets beyond corporate debt. One thing is for certain, we will not experience a V shaped recovery… it will take time.