Global high yield: Stimulus fuels the march of the zombies

by Aviva Investors

2 Dec 2020

Zombie companies are the talk of the town. Will they limp on forever, storing up trouble for investors, or can they revive and thrive after COVID?

• The Zombies are coming: Businesses that are barely surviving but propped up by unprecedented central bank support, with profits lower than interest payable on their debt as a result of the pandemic


• Although default expectations have fallen, credit selection based on sound fundamental analysis is ever critical in portfolio construction
  


• Aviva Investors Global High Yield is strategically oriented toward higher quality in developed markets high yield bonds with a 12-year proven track record

Halloween is synonymous with zombie movies. In almost every film, the plot is the same: a clutch of survivors resists as the living dead contaminate everyone around them.

Never has this appeared so apt as in 2020. Dramatic falls in revenues are pushing companies to the brink but, propped up by central bank support, they have managed to survive. These are the zombie firms which, by the definition used by bond investors, are issuers generating profits lower than the interest payable on their debt for at least three years. To stay in business, these firms must borrow more just to pay the interest they owe.  

The big focus for investors is how to avoid falling victim to the continuing march of the zombies. In the article, we discuss the impact of the extraordinary monetary policies implemented by central banks in response to COVID-19. While this support remains critical, investors should remember the importance of analyzing individual business models and companies’ prospects for improved profitability over the medium term.

Elixir of life

Almost every sector has been disrupted by COVID-19, particularly consumer-driven services. The latter has seen significant issuance as companies scrambled to horde cash. This has been possible thanks to the generosity of central banks pumping liquidity into markets and, in the case of the US Federal Reserve, explicitly supporting high-yield issuers through its bond purchases.¹

The European Central Bank is not buying high-yield directly, but there is a trickle-down effect from its support to investment-grade issuers, and from investment-grade investors searching for higher yields. That said, the pickup in fund flows has remained more muted in Europe than the US (Figure 1).

Figure 1: Strong demand for high yield

Source: Aviva Investors, Lipper, as of June 26, 2020

Rise of the zombies

Coupled with massive debt issuance, a steep decline in revenues has created a cohort of zombie companies. Unsurprisingly given the economic backdrop, the number of zombies is rising, as Figure 2 shows.

Figure 2: US zombie companies are on the rise

Source: Joe Rennison, 'Pandemic debt binge creates new generation of 'zombie' companies',

The Financial Times, September 14, 2020

The first worry for investors is if these companies begin to default en masse once their resources are exhausted and they can no longer find new lenders. On this front, the news is reassuring for now.

“Expectations of defaults are decreasing and should stay low as long as monetary policy remains supportive,” says Brent Finck, senior high-yield portfolio manager at Aviva Investors. “In addition to central banks’ bond buying, the liquidity they are injecting into markets needs to be invested somewhere, allowing companies to find takers for their issuance. There is no expectation for this to stop in the near future."²

During the sell-off in March, J.P. Morgan projected default rates for 2020 at above 10 per cent. This was when concerns over the economic impact of COVID-19 were heightened and prior to the announcement of fiscal and monetary support.

By October, forecast default rates for US high-yield bonds were down to 6.5 per cent for 2020, and only 3.5 per cent for 2021.³ Although dismal growth suggests bankruptcies should rise, they are so far lower than in 2019 (Figure 3).

Figure 3: Insolvency trends year on year

Source: The Economist, LCD, S&P Global Market Intelligence, American Bankruptcy Institute,

Banque de France, Destatis, The Insolvency Service, Tokyo Shoko Research, as of September 26, 2020

Zombification or new lease of life?

It could go wrong. Much of the recent news flow underlines the risks of zombie companies surviving indefinitely, keeping capital invested in less productive parts of the economy with a dampening effect on inflation, interest rates, innovation and growth.⁴

However, in free-market economies, it should always be possible for entrepreneurial companies to win business.

In fact, while the BIS report suggested the survival of zombie companies may crowd out investment and employment in healthy firms, this is not evidenced across the board.

For instance, when Japan finally started to tackle weakness in its banking sector in the 2000s, the share of zombie firms fell rapidly, in part because those firms became profitable again.⁵

Where COVID-19 makes it more difficult for investors is that low revenues and high leverage can be found both in companies that were already on their way to zombification before the pandemic, but also in previously healthy firms that now need cash to survive long enough to resume activity.

“Having liquidity is helpful, but it won’t create revenues and it won’t create earnings. Managers have to be increasingly diligent when analysing companies’ leverage and cash flows,” says Josh Lohmeier, head of US investment-grade credit at Aviva Investors.⁶

Cruise lines are a good example. Until the pandemic is under control, they are almost entirely unable to sail and have no revenue potential, while burning cash ($650 million a month for CCL, for example).⁷

“The sector has seen significant issuance as firms raise liquidity on the presumption that, if they can survive until the end of 2021, a vaccine will have resolved the issue, allowing them to resume operations and profit-making,” explains Paul Janowitz, senior credit analyst at Aviva Investors.

The same is true within sectors, where some companies are doing better than others, even though all are easily placing their debt. For example, Las Vegas casino operators are struggling and should have restructured without Federal Reserve support,⁸ whereas regional casinos began recovering once lockdowns lifted.⁹

The devil is in the detail
What is less talked about, but more concerning, is covenant strength. With continued strong demand for high-yield bonds and record issuance from businesses trying to stay afloat, the quality of covenants is deteriorating (Figure 4).

Figure 4: Moody's Covenant Quality Indicator above 4.40 for a 16th consecutive month in August

Source: Moody's Investors Service, as of September 15, 2020. Note: CQI reflects all high-yield bonds, including high-yield lite. High-yield-lite bonds lack a debt incurrence and/or a restricted payments covenant and automatically receive the weakest possible CQ score of 5.0 

Covenants typically impose restrictions on the amount of leverage permitted on a company’s balance sheet, complemented by an obligation to seek existing bondholders’ approval before issuing additional debt and potential penalties to pay when leverage hits certain ratios.

Across high-yield markets, strong demand has given issuers more bargaining power to loosen those restrictions. Some have also found loopholes whereby the amounts used to report their leverage levels do not reflect actual cashflows. This allows them to add debt without triggering ratios, consent fees or seek approval from existing investors.¹⁰

At the higher quality end, this year has also seen an increase in fallen angels.¹¹ “As investment-grade companies, they typically did not require covenants, and many have continued to issue bonds as high-yield firms without changing their practices,” says Sunita Kara, senior global high yield portfolio manager at Aviva Investors.

This is worrying because covenants are designed to protect existing investors from exposure to unwanted risk. Without these in place to restrict issuance, the quality of bonds may degrade without investors being adequately compensated for the risk, or consulted as to whether they are willing to take it on.

Combined with the difference in fundamentals across sectors and firms, weaker covenants are leaving investors exposed. Understanding companies’ leverage levels but also their business models and prospects for renewed profitability in the medium term is more important than ever to avoid falling victim to the continuing march of the zombies.

Sources

¹ Joe Rennison, Robin Wigglesworth, Colby Smith, 'Federal Reserve enters new territory with support for risky debt,' Financial Times, April 9, 2020. https://www.ft.com/content/c0b78bc9-0ea8-461c-a5a2-89067ca94ea4

² Webcast, ‘The year of living dangerously: Don't fight the central bankers,’ Aviva Investors, May 2020. https://event.on24.com/eventRegistration/EventLobbyServlet?target=reg20.jsp&partnerref=internalinvitation&eventid=2328323&sessionid=1&key=33FA64219F290844D251B7C27052E7AC®Tag=&sourcepage=register

³ ‘Default Monitor - High Yield and Leveraged Loan Research,’ J.P. Morgan North America Credit Research, October 1, 2020.

⁴ ‘Why COVID-19 will make killing zombie firms off harder,’ The Economist, September 26, 2020. https://www.economist.com/finance-and-economics/2020/09/26/why-covid-19-will-make-killing-zombie-firms-off-harder; Wolf Richter, ‘The zombie companies are coming,’ Wolf Street, August 26, 2020. https://wolfstreet.com/2020/08/26/the-zombie-companies-are-coming/

⁵ ‘Why COVID-19 will make killing zombie firms off harder,’ The Economist, September 26, 2020.

⁶ Chris Sloley, ‘Why this IG chief is worried about a ‘false sense of security’ in bonds,’ Citywire, July 29, 2020. https://citywireselector.com/news/why-this-ig-chief-is-worried-about-a-false-sense-of-security-in-bonds/a1384853

⁷ 'Carnival Corp & plc (CCL) Q2 2020 Earnings Call Transcript,' The Motley Fool, July 10, 2020. https://www.fool.com/earnings/call-transcripts/2020/07/10/carnival-corp-plc-ccl-q2-2020-earnings-call-transc.aspx

⁸ Erin Arvedlund, ‘Fed’s Jay Powell creating ’zombie’ firms, says noted Fed watcher,’ The Philadelphia Inquirer, September 7, 2020. https://www.inquirer.com/business/federal-reserve-inflation-danielle-dimartino-booth-jerome-powell-trump-20200907.html

⁹ ‘Home and leisure in a pandemic: Girls (and boys) still want to have fun,’ Aviva Investors, October 13, 2020. https://www.avivainvestors.com/en-gb/views/aiq-investment-thinking/2020/10/covid-19-impact-on-home-and-leisure/

¹⁰ 'North American Bond Covenant Quality Indicator' and 'Covenants — Europe' reports, Moody's Investors Service, respectively September 15 and August 26, 2020.

¹¹ Sunita Kara, ‘The impact of COVID-19 on global high yield,’ Aviva Investors, April 20, 2020. https://www.avivainvestors.com/en-gb/views/aiq-investment-thinking/2020/04/the-impact-of-covid-19-on-global-high-yield/

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