They are easy credit creations, beneficiaries of central bank largesse. And now that the era of unconventional monetary policy is over, they face a challenge like never before.
These are America’s zombie companies, companies that don’t earn enough to cover their interest costs, let alone make a profit. From meme-favorite AMC Entertainment Holdings Inc. to household names like American Airlines Group Inc. and Carnival Corp., their ranks have swelled in recent years, comprising around a fifth of the 3,000 largest publicly traded companies. of the country and representing approximately $900. billions in debt.
Now, some say, their time may be running out.
Companies that could once rely on virtually unlimited access to bond and loan markets to stay afloat are being pushed back as investors bracing for a recession turn off the tap on all but the most creditworthy issuers. The lucky few who can still find willing lenders face significantly higher borrowing costs as the Federal Reserve raises interest rates to tame inflation by more than 8%. With soaring input costs poised to eat away at profits, that leaves a wide swath of corporate America with little room for error.
The end result could be a long series of bankruptcies unprecedented in recent memory.
“When interest rates are at zero or near zero, it is very easy to get credit, and in those circumstances the difference between a good and a bad business is narrow,” said Komal Sri-Kumar, Chairman of Sri-Kumar Global Strategies. and former TCW Group Chief Global Strategist. “It’s only when the tide is out that you know who’s swimming naked.”
Of course, there have been a number of times over the past decade when zombie companies have appeared on the brink of accountability, only to have the markets dumped at the last minute. But industry watchers note that what makes this period different is the presence of runaway inflation, which will limit policymakers’ ability to come to the rescue at the 11th hour.
This does not mean that a wave of defaults is imminent. The Fed’s unprecedented efforts to bolster liquidity after the onset of the pandemic allowed zombie firms to raise hundreds of billions of dollars in debt financing that could last for months or even years.
Yet as the central bank scrambles to quickly undo the stimulus, the effects on credit markets are already evident.
Junk-rated companies, those rated below BBB- by S&P Global Ratings and Baa3 by Moody’s Investors Service, have borrowed just $56 billion in the bond market this year, down more than 75% from one year ago.
In fact, May’s issuance of just $2.2 billion is expected to be the slowest of the month in data dating back to 2002.
“If rates hadn’t been this low, many of them would have fallen by now,” said Viral Acharya, a professor at New York University’s Stern School of Business and former Reserve Bank deputy governor. of India. “Unless we have another major financial crisis, I don’t think the Fed’s bailout capacity is necessarily that high. Especially when they explicitly say they want to reduce demand. How is this compatible with keeping these companies alive? »
Raising cash in the leveraged loan market hasn’t been much easier as tighter monetary policy could tip the US into a recession. New loans of less than $6 billion in May compared to more than $80 billion in January, according to data compiled by Bloomberg.
Worse still, companies that have piled up loans on their balance sheets to ride out the pandemic are now facing the daunting prospect of higher interest rates that are eating away at a growing share of their profits.
The Fed is expected to raise its target rate by 3 percentage points by the end of next year, according to Bloomberg Economics, pushing up floating rate benchmarks that underpin corporate lending.
Even the few speculative firms capable of raising funds have to pay to exploit the market.
Cruise ship operator Carnival sold $1 billion in eight-year tickets that yield 10.5% earlier this month, a stark contrast to the $2 billion it was able to raise seven months earlier at a rate of 6%.
Meanwhile, U.S. corporate profits saw the biggest first-quarter decline in nearly two years as some companies struggled to pass on rising costs for materials, transportation and labor. on consumers.
Of the 50 largest zombies by outstanding debt, half reported lower operating margins in their latest results, according to data compiled by Bloomberg. The trend is only going to get worse, according to Viktor Hjort, global head of credit strategy at BNP Paribas SA.
“Price increases have only been fairly recent,” Hjort said. “We’ll see that start to impact second and third quarter results.”
Zombie companies get their nickname from the way they tend to stumble, weighed down by their debt burden, but with enough access to capital markets to meet their obligations. They slow overall productivity and economic growth because they cannot afford to invest in their businesses and tie up assets that could be better used by more powerful players.
Although the exact criteria used by market experts may vary, many economists consider zombies to have interest coverage ratios of less than one over a given period. To account for the impact of the pandemic, Bloomberg’s analysis looked at the 12-month operating profit of companies in the Russell 3000 index against their interest expense over the same period.
About 620 companies have not earned enough to meet their interest payments over the past year, down from 695 12 months earlier, but still well above pre-pandemic levels.
Matt Miller, a spokesman for American Airlines, said the company had “a strong cash balance of $15.5 billion and expects to be profitable in the second quarter.”
A Carnival representative said the company plans to sail its entire global fleet by the end of the year and has worked over the past 12 months to refinance its debt at more attractive rates.
AMC did not respond to a request for comment.
One name that is no longer on the list is Exxon Mobil Corp., one of the biggest beneficiaries of rising oil prices and widening fuel margins. The explosion in profits allowed the energy giant to reduce its debt to $48 billion, from around $70 billion at the end of 2020.
A representative for Exxon did not respond to a request for comment.
According to Vincent Reinhart, chief economist at Dreyfus and Mellon, any significant increase in bankruptcies will make it harder for the Fed to engineer a so-called soft landing that allows the United States to avoid a recession.
“You’re concerned that the mechanism of financial fragility in general, zombie firms in particular, is an accelerator of what the Fed is doing,” Reinhart said. “When rates rise, it pushes more of these companies into distress and amplifies the Fed’s tightening of financial conditions and credit availability.”
Equity investors may already be aware of these risks. Zombie companies in the Russell 3000 have plunged 36% on average over the past year, compared to just 4.3% for the broader gauge, according to data compiled by Bloomberg.
Yet even as some zombies end up bankrupt, effectively killing them, new ones will emerge, as inflation pushes more businesses into distress. The number of undead companies may stay near current levels or even increase for some time, according to Noel Hebert, director of credit research at Bloomberg Intelligence.
“The combination of interest rate hikes and inflation will produce more zombies,” Hebert said. “By the end of the year, we will have more.”
Reporting by Lisa Lee for Bloomberg News.