Coronavirus shock is pushing highly indebted 'zombie' companies towards financial ruin - and a risky $1 trillion market is already showing the damage a recession would do
- The coronavirus pandemic could throw the US economy into a recession this year.
- If that happens, companies that amassed a ton of debt during the expansion would struggle to repay and stay in business as their cash flows shrink.
- The $1 trillion leveraged-loan market has been underperforming and seeing historic outflows, indicating that investors are already worried.
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The coronavirus pandemic and its disruptions to everyday life have hiked the threat level of a global recession this year.
As self-quarantines, conference cancellations, school closures, and other changes slow economic activity, companies are going to suffer cash flow losses. Multiple large firms including Apple and Microsoft have already told investors to discard pre-coronavirus forecasts for revenues.
But tech giants like these two are not the most at risk, thanks to their plump cash balances.
A downturn would be far more dangerous for so-called zombie companies that owe their existence to debt. Because such firms only make enough money to cover interest payments, they risk defaulting or getting credit downgrades if the economy contracts.
The Bank of International Settlements estimates that 16% of US companies fall into this category.
Zombie companies exploded in number due to the near-zero interest rates that prevailed after the 2008 financial crisis. This era, which coincided with the longest economic expansion, allowed companies to cheaply fuel their growth with debt.
Moreover, lenders relaxed borrowing standards and made it easier for less credit-worthy corporations to heap debt. Covenant-lite loans that do not require borrowers to meet some regular standards make up about two-thirds of the market. That's up from about 5% a decade ago, according to data compiled by Capital Economics.
Investors have not been blind to the danger of this trend. Several experts - and even Federal Reserve officials - have warned that these companies would worsen the next recession.
"Unless leveraged lending is reined in, when a large enough shock to corporate incomes comes along (and one will eventually!) a corporate subprime financial crisis will be almost inevitable," Simon MacAdam, a global economist at Capital Economics, said in a recent client note.
Leveraged loans sense danger ahead
The higher yields that investors have been able to earn by funding risky debt binges has made it difficult to stay away.
Proof of their keen interest can be found in the leveraged-loan market that grants variable-rate credit to companies with non-investment-grade ratings. Outstanding loans have grown from $497 billion in value in 2010 (when the credit crisis was still a fresh wound) to more than $1 trillion.
The chart below illustrates what fueled this growth: the hunt for yield in a low-return, post-crisis world. On average, leveraged loans provided the highest yield relative to their outstanding value.
Goldman SachsInvestors are now recalculating the risk-reward trade-off as the risk of a recession looms. Last week, they pulled $2.2 billion from bank loan funds - the second-largest redemption ever according to Goldman Sachs.
Investors are also becoming more discerning about their risk-taking in an economy that is poised to contract.
High-yield bonds, also called junk because of their low-quality credit profiles, are outperforming leveraged loans as coronavirus fears pummel risk assets.
Goldman Sachs Goldman's Karoui does not expect investors' appetite for leveraged loans - and risk assets more broadly - to improve anytime soon.He gave three reasons for this view: The market does not know how effective Fed policy will be in the face of an economic shock, flat earnings growth this year could spur credit defaults, and valuations remain expensive despite the recent sell-off.
Karoui recommends that investors underweight leveraged loans in their portfolios relative to high yield. "This remains one of our highest conviction views heading into 2020," he said.