“A prudent man foresees evil and hides himself; The simple pass on and are punished.” Proverbs 27:12
Around the time of Halloween last year, I wrote a blog discussing the presence of zombies among us. No, not those zombies. I was talking about corporate zombies. As I explained in last year’s blog, corporate zombies are companies that struggle to pay the interest on their debts. Yes, I said that correctly. These companies aren’t just struggling to pay back their debts. They are actually borrowing money to pay the interest on their debts. “These things exist in real life,” you might ask? Yes, they are very much a reality. And in light of Halloween this year, I wanted to revisit the topic of what created these things in the first place, and why the zombies are still here.
To begin with, I would like to offer the definition of a zombie company provided by the Bank of International Settlements (BIS). According to the BIS, companies are considered ‘zombies’ if they are:
- at least 10 years old, and
- have an interest coverage ratio of below 1.0 for the past three years.
The interest coverage ratio describes a company’s ability to pay the interest on its debt. If it’s below 1.0, it means it’s earnings cannot pay the interest on its debt. Imagine for a moment that you couldn’t pay the interest on your mortgage payment. What would we normally call that? Preforeclosure, perhaps? Regardless, it’s a bad situation to be in. The fact that the BIS sets such strict limits on its analysis is indicative of just how hard it is for a company to meet these parameters. Corporate zombies really are dead, even though they are still officially in business.
Last year, the BIS reported that approximately 12% of companies they analyzed are ‘zombies.’ At first, this may appear to be a relatively insignificant number. But for reasons I outlined previously, this is an incredibly high percentage considering how low of a threshold the analysts set. If a company can’t pay 1.5 times their interest with their earnings, in most industries they are considered very risky. Investors – if they are willing to loan more money at all – will demand a higher interest rate if these more risky companies wish to receive more debt financing. Unless earnings increase dramatically, these companies typically don’t survive for long.
So when the BIS narrows its focus to those companies that have been this way for years, they are really scraping the bottom of the barrel. To go three years without being able to pay the interest on outstanding debt is to be, for all intents-and-purposes, insolvent. These companies are essentially borrowing money to pay the interest on previously borrowed money. They are already bankrupt, even though their doors are still open. In a healthy economy that is still expanding, 1 in 10 companies should not fall into this category. Something is clearly wrong in the corporate bond market.
An Even Bigger Problem
Fast forward to this year, I recently came across another analysis outlining an even bigger problem. Below are the current credit ratings of the U.S. corporate bond market. Companies with an AAA credit rating are financially strong. As we move along the x-axis, the ratings identify companies that are increasingly risky. CCC is the worst rating, which is why the number of companies (the dark blue line) in that category is so few. They simply do not survive long.
The largest section in terms of dollar value is in the middle. BBB is still “investment grade” (i.e. financially strong), but just barely. While these companies are “healthy” on a macro scale, they are teetering on the edge of becoming “junk bonds” (i.e. BB or lower). And because they comprise over 40% (with some sources estimating over 50%) of the entire bond market, this is where the problem lies.
How The Problem Could Get Worse
In looking at the above graph, we intuitively know that most (if not all) of the ‘zombies’ the BIS was identifying fall into the B or CCC/C categories. These companies really are on life-support, and their poor financials reflect their ‘junk bond’ status. According to a recent study by the International Monetary Fund (IMF), however, this could be just the tip of the iceberg:
Corporations in eight major economies are taking on more debt, and their ability to service it is weakening. We look at the potential impact of a material economic slowdown—one that is as half as severe as the global financial crisis of 2007-08. Our conclusion is sobering: debt owed by firms unable to cover interest expenses with earnings, which we call corporate debt-at-risk, could rise to $19 trillion. That is almost 40 percent of total corporate debt in the economies we studied, which include the United States, China, and some European economies.
This is telling. Suppose for a moment we have a ‘material’ economic slowdown which is ‘half as severe’ as the Financial Crisis. In other words, this slowdown would be so modestly ‘material’ as to almost be “immaterial”. But suppose we avoid a significant recession and instead, the economy just slows down. What is the IMF telling us? The IMF’s data suggests we should expect almost 40% of the global corporate bond market (the vast majority of which in the US) to become corporate zombies. Or, if we want to put some lipstick on the financial pig, 4 in 10 bonds could become “debt-at-risk” of imminent default.
What This Means For You
Marketwatch recently ran a story on a report from Bank of America, declaring the “end of the 60-40 standard portfolio”. While I plan to discuss the death of the 60/40 portfolio in my next post, I am only going to make a passing point regarding its relevance. Since most investors still rely on 60% equity and 40% bond portfolios for their retirees, most of their clients are in these models. This applies to the vast majority of individual investors as well as those who invest in 401k “target date” funds.
The reasoning for following this model is fairly straight forward. In the midst of an economic slowdown, bonds typically rise in price as investors flea more volatile assets such as stocks. This is why the traditional 60/40 portfolio has been advisors’ “go-to” portfolio for decades. It provides retirees downside protection in bear markets and a fair amount of income in bull markets. But for numerous reasons, this strategy’s effectiveness appears to be coming to an end.
The truly frightening thing about the IMF and BIS’s data is the incredible vulnerability of the bond market. In even a moderate economic slowdown, the corporate bond market is likely to see massive defaults. At the same time, the stock market will be dropping as panic-selling sets in. This will leave traditional 60/40 portfolios with no downside protection. For retirees who need income, they will either sell their holdings to provide for their lifestyle or cut their spending. Either proposition is difficult and will lead to further deterioration in asset prices and economic activity.
How This Plays Out
I’m not bloviating when I say the next economic slowdown is likely to bring on a corporate zombie apocalypse. If 4 in 10 companies are no longer able to service their debt with earnings, we are in for trouble. As a result, we will see two things occur.
First, central banks across the world will push interest rates downward in an effort to “save” the economies from further pain. Lower interest rates, they suppose, will increase the availability of credit. This will allow these zombie companies to continue operating by paying their expenses with more debt. The Central Bankers will continue hoping that at some point, increased earnings will magically appear and growth will allow these zombie companies to miraculously heal. If this were a zombie movie, the mad-scientist injecting zombies with even more of the virus that caused them to become zombies in the first place. Cheap credit created these unstable companies. And the Federal Reserve believes that even cheaper credit will make them better. It’s like multiplying two negatives to get a positive. You can’t argue with math, right? Anyway, while this hasn’t worked in the past that won’t stop the Feds from trying again.
Second, there will be a mad rush away from the zombies. In the movies, survivors always head to the country for safety from the zombie assault. In this scenario, investors are likely to flee to the US treasury market. We’ve already seen an increased demand for treasuries in the past 12 months, with our long-duration holdings up over 30%. While this is good for our clients, it isn’t good for the economy as a whole. This trend will push all interest rates lower, thereby continuing the downward spiral in economic conditions.
Most investors are simply unprepared for what is coming. They continue to believe their 60/40 portfolios will do fine. But in addition to the stock market being 50-60% above it’s fair value, the bond market is incredibly vulnerable. It’s time for investors to change their strategies. By the time you see the corporate zombies on the front lawn, it’ll be too late to move.