The Zombie (Company) Apocalypse Is Coming

The Zombie (Company) Apocalypse Is Coming
Stéphane Renevier, CFA

3 months ago3 mins

You never see a zombie movie with just one zombie. Where there’s one, there are many. And, well, same goes for zombie companies. Years of near-zero interest rates have given rise to a new crop of so-called zombie companies – firms that barely generate enough revenue to cover their interest payments and are sustained primarily by easy access to dirt-cheap borrowing. These businesses are more about survival than adding economic value, and have no room for growth or innovation. As long as they can refinance their debt, they exist. But cue the end of the free money buffet, and suddenly, these zombies get the shakes.

Today’s zombie company apocalypse is a biggie. As you can see in this chart from Fathom Consulting, the true zombies – those that couldn’t cover their interest costs with earnings before interest and tax (EBIT) for three straight years – account for over 20% of all firms. But loosen the criteria to just one year of EBIT not covering interest, and that figure climbs to nearly 30%. That’s right, nearly a third of all US companies are skating on thin ice, with too little EBIT to handle their interest payments. And when their interest rates payments climb higher – which will happen when they need to refinance their debt at higher rates – even more firms will join the zombie club, with the weakest among them potentially forced to default.

Grim as that may be, it doesn’t mean we’re necessarily headed for a severe recession. Think of this as a kind of economic spring cleaning – and the downfall of weaker zombie companies as part of the rinse cycle. These firms have been taking up space without really contributing, so the economy will be a bit sparklier when they’ve been washed away, making room for some real movers and shakers to step up. In other words, you can have a pretty big surge in defaults without a huge consequence to the broader economy.

That said, an army of zombie defaults could easily spook investors. And to complicate matters, a chunk of risky debt has shifted to the less transparent, more intricate private markets, which are known for their higher leverage and lower liquidity. That adds a layer of uncertainty over the whole scene, which could cause investors’ sentiment to swiftly decay and drive them to seek higher yields on corporate loans. Those even higher financing costs could spark even more defaults. And, sure, the Federal Reserve (the Fed) could soon cut interest rates, but that might not be enough to offset the negative impact of tighter financing conditions for companies. In fact, it could actually land us in what’s consistently been the least hospitable environment for stocks.

History tells us stocks often get hit hardest when the Fed eases but credit gets tougher (think: rising corporate bond yields). Right now, credit’s holding steady, but with US corporate bankruptcies aiming for a 2010-high record, this calm might not last. Plus, consider the growing number of companies needing to refinance their debt at heftier rates soon, and it’s clear how quickly the scene could turn grim.

For now, it’s all sunshine and rainbows: inflation’s heading in the right direction and the economy’s remained robust. And there’s a real chance that continues. But investing isn’t just about the base case scenario, so don’t lose track of the risks. As past crises and sci-fi films have taught us, this is often how a tricky situation escalates into a full-blown catastrophe. In the world of investing, markets often choose the moments of greatest optimism to remind investors of the importance of humility.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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