Unprecedented central bank responses to the financial crisis have created a number of market distortions. The era of artificial liquidity has spawned more than a few monsters. Governments and corporates alike have gorged on cheap debt. Among them, zombie companies.
Zombies are firms that show no signs of life but somehow continue to survive. Inefficient, stagnant, with scant hope of salvation, they barely manage to stay afloat. They are unable to repay the principle of their outstanding debt and too weak to invest or grow. In other times they would slip quietly into the ground, consigned to rest in peace. But somehow in this post-QE world they stagger blindly on.
A common definition is firms older than 10 years whose earnings before interest and tax (EBIT) are lower than interest payments on outstanding debt for three or more consecutive years. Banerjee and Hofmann, 2018; The rise of zombie firms: causes and consequences; BIS Quarterly Review, September 2018. confirms that the number of firms that fit this description is on the rise.
What is more, they are surviving for longer. These days, almost 90 per cent of such firms neither cease to operate nor become profitable enough to cover interest payments in the following year.
Simple averages of zombies as a share of all listed non-financial firms in the Worldscope database from Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the UK and the US. Zombies are defined as firms with an interest coverage ratio less than one for three consecutive years and over 10 years old. Source: Banerjee and Hofmann (2018), September 2018.
The problem with zombies
Low-productivity firms take up resources but use them less efficiently than other firms. Every stagnant company occupying a spot on the high street, employing staff, buying advertising and receiving funding reduces availability and raises costs for other market participants.
A higher proportion of lower productivity firms means lower average wages for everyone. While they do provide employment and pay taxes, a higher share of capital sunk in such companies lowers the investment and employment growth of other firms in the same industry. A McGowan et al., 2017; The walking dead? Zombie firms and productivity performance in OECD countries. estimated that investment by non-zombie firms would have been two per cent higher by 2013 had the proportion of zombies remained at 2007 levels.
Labour productivity (gross value-add) per worker in constant 2010 US dollars (density function) of all listed non-financial firms in the Worldscope database from Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the UK and the US. Zombies are defined as firms with an interest coverage ratio less than one for three consecutive years and over 10 years old. Source: Banerjee and Hofmann (2018), September 2018.
The existence of stagnant incumbents is also a barrier to entry for market entrants. New firms must clear a higher productivity threshold to offset the lower market profitability in industries that have a high proportion of such firms. This barrier to entry reduces dynamism at an industry level and increases inefficiency in the economy. Productivity is closely related to wage growth, so fewer active low-productivity firms benefits everyone with a higher average wage level.
Where do zombies come from?
Two reasons are often given as explanation for the rise of stagnant companies: interest rates and the health of banks.
The data show that such firms have been on the rise since the late 1990s. During this time, rates have been on a steady march downward. Lower rates mean less pressure on managers to cut debt, restructure, or shut up shop. It’s cheaper and easier to refinance and roll over existing debt. In addition, yield hungry investors are willing to accept riskier investments to meet their return objectives.
How healthy banks are can also influence the number of such firms. Banks with weak balance sheets, a feature of the period following the financial crisis, are more willing to roll-over non-performing loans rather than write off bad debt.
Source: Refinitiv, Fidelity International, November 2018.
Conditions now could bring a day of reckoning
Rates well below historical averages and quantitative easing over the last 10 years have led to highly liquid monetary conditions. Companies have found demand for bonds strong and tapping credit markets easy. But this has bred complacency.
The number of bonds in the Bloomberg Barclays US Corporate Bond Index has almost doubled since 2010. The proportion of BBB debt in investment grade indices is increasing, at the same time as the leverage of BBB rated companies is increasing.
Source: Fidelity International, October 2018. Leverage defined as debt/EBITDA. Data is Fidelity’s proprietary credit research.
The market value of US BBB-rated debt, the lowest notch still considered investment grade, is now twice that of the entire US high yield market, meaning that any downgrades in the event of economic difficulties may not be easily absorbed and refinancing costs will rise.
Despite the worsening of credit conditions, spreads are still well below their long-term averages.
Source: Bloomberg, Fidelity International, September 2018. ICE BofAML global indices used.
Recessions as zombie slayers
So, what can kill the zombies? There is one school of thought that argues recessions are a natural and constructive part of market economies. Companies need space to innovate. If you regulate too hard then you risk stifling that innovation. But lighter regulation breeds market failures that reduce efficiency. Periodic recessions have the potential to flush the system, trim the deadwood and encourage the creative destruction that can lead to more efficient allocation of resources.
But the financial crisis did not cleanse the system. Central bankers decided the risk of systemic failure was too great and acted accordingly with bailouts and quantitative easing, reducing the potency of the recession to reallocate capital more efficiently. And the unprecedented liquidity provisions put in place then lasted longer anyone predicted at the time, providing a fertile breeding ground for more firms with low productivity to survive in the time since.
The next recession
The current economic cycle is already one of the longest on record. Predicting when it will end is difficult. While we can say with a high degree of certainty that there will be a recession of some description within the next ten years, how central banks will react to it is very much unknown. In the US and many emerging markets there is at least some space to cut rates but not so in Europe and Japan. With the political order changing in Germany, appetite to bankroll monetary stimulus may be reduced in future. The course of populist politics could therefore be a deciding factor for firms just managing to stay afloat in today’s climate of easy credit.
However, expectations around what is normal in a recession have changed in the last 10 years. Greater leverage now means a return to what used to be thought of as unconventional monetary policy may be required again. And the increasing prevalence of firms struggling to meet their interest payments even at current interest rates might create a vicious circle that encourages central bankers to flood the financial system with liquidity in the event of a downturn which in turn breeds more of such firms.
On the other hand, banks are in a stronger position now than before the financial crisis. This should reduce the amount of non-performing loans that are extended and hence force more struggling companies to reduce debt or declare bankruptcy in the event of a downturn.
How to avoid zombies
Not all companies with low interest coverage ratios are zombies and not all low-productivity companies stay that way indefinitely. Indeed, using our definition - a firm older than 10 years with an interest coverage ratio of less than one, for three or more consecutive years - then Tesla would qualify. It’s not a name that many would associate with stagnant inefficiency. Identifying the firms to avoid is not always easy. So how can investors reduce their exposure to unwanted risks?
We recommend a thorough examination of reset rates. Rates have risen from historic lows in the last 12 months and refinancing costs are expected to rise in years to come. A company may have enough free cash flow to pay interest costs today, but may struggle if they need to refinance at a higher rate next year. And of course, free cash flow might evaporate in the event of a downturn. Working out when and at what price refinancing will take place gives an idea of how much cash flow is needed now to provide an appropriate cushion. Look for firms with strong fundamentals and a commitment to support their balance sheets.
One thing fixed income investors need to be careful of in this environment is single issuers. There have recently been a number of companies taking advantage of current monetary conditions to raise cash through debt markets for the first and, most likely, last time. Among members of the Bloomberg Barclays US Corporate Index, 38 per cent of companies now only have one or two bonds outstanding.
Such debt is often locked away after release and very minimally traded. As long as economic conditions remain supportive, this scenario should be fine. However, bond investors prefer corporate issuance plans with a range of maturities so they can calculate a yield curve and accurately price bonds. Holders of the debt of single issuers with low interest coverage ratios could find buyers in short supply if market liquidity dries up in the event of a downturn.
We don’t know when it will come, but the next 10 years will almost certainly see a recession of some description. Recessions cause hardship for many, but the unique conditions since 2008 could make the long-term consequences of the next one particularly positive for productivity and wages.
But for now, the zombies walk among us. Years of cheap debt has seen to that. We believe the market is not paying enough attention to the amount of debt coming to maturity in the next few years that will need refinancing at a higher rate. Even reasonable interest coverage ratios today might not be enough in a few years’ time. And when the downturn does come, these stagnant, low-productivity companies will be the hardest hit. You have been warned.
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