Halloween: The zombie companies are rising

Ten-year yields are near 5 per cent and base rates stand at 5.5 per cent, and the companies kept alive by cheap money are running out of time. For more than a decade zero rates kept unviable businesses on life support. Cheap covenant-lite debt let corporate 'zombies', firms whose operating profits do not cover their interest bills, multiply in public and private markets.

How the undead multiplied

The conditions were created after 2008. Central banks cut rates to near zero and bought bonds, pushing investors to hunt for yield wherever they could find it. Lenders competed to fund leveraged buyouts, and to win deals they dropped the covenants that once let them step in when a borrower's finances deteriorated. The pandemic repeated the cycle in compressed form: in 2020 and 2021 rates went back to zero, central banks backstopped credit markets, and weak companies were able to borrow at the lowest coupons in history.

The measure of a zombie is its interest coverage ratio, operating profit divided by interest expense. A ratio below one means the firm cannot pay its interest from its business and must borrow more, sell assets or raise equity to stay current. For years that was sustainable, because the cost of rolling over debt kept falling. The arithmetic flips once rates rise: the same operating profit now covers a much larger interest bill, and firms that sat just above one fall below it.

Twenty-four months of maturities

A zombie survives only as long as it can roll over its debt at a tiny coupon. Debt issued after the pandemic starts maturing over the next twenty-four months, and these firms will have to refinance at rates that swallow all their cash flow. Private equity owners and distressed-debt funds will not keep covering operating losses when risk-free government debt pays 5 per cent.

Floating-rate borrowers are already feeling it. Leveraged loans, the main financing tool for private-equity buyouts, reset their coupons with short-term rates, so their interest bills rose as the Federal Reserve lifted its policy rate from near zero in March 2022 to its current range. Companies that issued fixed-rate high-yield bonds have been protected until those bonds mature, which is why the refinancing wall matters: it is the moment when their costs catch up with the market.

Raising equity is rarely an escape. Shareholders in a company whose profits cannot cover its interest bill are in effect being asked to fund its creditors, so new shares can be sold only at deep discounts that dilute existing owners heavily. Asset sales run into the same problem, since buyers know the seller is under pressure. That leaves most zombies with three options: a negotiated debt restructuring, a sale to a stronger rival or bankruptcy.

The first casualties

The failures have started. Yellow, a large American trucking company, filed for bankruptcy in August after years of losses propped up by a federal pandemic loan. Rite Aid, the pharmacy chain, filed in October under the weight of debt and opioid litigation. WeWork, the flexible-office provider, skipped interest payments at the start of October and warned in August that there was substantial doubt about its ability to continue. Each had its own problems, but all had relied on cheap refinancing to paper over businesses that did not generate enough cash.

Lessons from Japan

Japan in the 1990s offers the best-studied example of what zombies do to an economy. Banks, reluctant to recognise losses, kept lending to insolvent borrowers, and those firms held down prices and wages in their industries, crowding out healthier competitors. Economists including Ricardo Caballero, Takeo Hoshi and Anil Kashyap later showed that sectors with many zombies had less job creation and lower productivity growth. The lesson is that propping up failing firms delays pain but spreads it across the rest of the economy.

Winners and losers

Lenders to the weakest firms will take losses. Holders of leveraged loans and the lowest-rated bonds face defaults, and recovery rates on covenant-lite loans tend to be lower because lenders could not intervene early. Private-credit funds, which have grown rapidly by lending to mid-sized buyouts, will test their valuations for the first time in a genuine downturn. Equity holders in over-leveraged companies are likely to be wiped out in restructurings.

The winners are healthier competitors, which will gain customers, staff and assets as zombies shrink or disappear. Distressed-debt investors with fresh capital will buy claims at discounts. Workers face short-term disruption, but over time capital and labour move to firms that can pay for them, which is how productivity rises.

Why the reckoning could be slower

The counterargument is that the reckoning may be drawn out. Lenders have become adept at amend-and-extend deals, pushing maturities out in exchange for higher coupons, and many private-credit loans allow borrowers to pay interest in kind by adding it to the principal. A resilient economy with low unemployment is also supporting revenues. If the Fed begins cutting rates next year, as futures markets expect, some borderline borrowers may survive.

Those tools buy time, but they raise the eventual bill. Adding interest to principal makes the debt larger, and extending maturities at higher coupons worsens interest coverage further. The indicators to watch are default rates on leveraged loans and high-yield bonds, the share of private-credit loans paying interest in kind, and the pace of bankruptcy filings among mid-sized companies.

Higher borrowing costs will finish off many of the zombies over the next two years. The restructurings will hurt lenders and owners, but should push capital towards firms that earn a return, and the leveraged-loan and private-credit markets will show the damage first.