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Cull of the corporate zombies

How bad will the corporate debt pain become in the coming year? Very very bad, according to Swiss Re’s economists. And possibly full-on awful.

So far the corporate bond market has fared OK in the great Everything Rout of 2022. Spreads have widened, losses have been severe, but there are no real signs of real stress or severe disorder.

But a report from the Swiss reinsurance group argues that given the murky economic outlook and the volume of weak “zombie” companies, a US junk bond default rate of 15 per cent — last seen in the wake of the global financial crisis — is possible.

The sharp reduction in corporate default rates in recent years has seen a rise in the number of zombie firms. We estimate that as of end-2021, zombie firms made up 20% of the US stock market. We expect a reversal of the trend as interest rates rise and as cash buffers built during the pandemic erode, which will see zombie firms default. Zombie companies face three major headwinds.

First, major central banks are continuing to raise interest rates to fight persistent inflation, which will also have the effect of lowering aggregate demand. Reduced demand in an environment of inflationary recessions means less revenues for many companies, and thus less cash for zombie firms to pay down their own debt.

Second, zombie firms were already struggling to make interest payments when rates were low. Higher financing costs will only amplify this challenge.

And lastly, lending to zombie companies is less attractive to banks and credit investors, as they can now benefit from higher rates by lending to higher-quality firms and still reap profits.

Though this is Swiss Re’s “severe recession” scenario, it’s a LOT higher than what many other analysts are predicting. Here’s what that looks like in chart format.

Fitch Ratings has forecast that the US junk bond default rate will rise from 1.2 per cent today to 2.5-3.5 per cent by the end of 2023, and 3-4 per cent by the end of 2024, compared to the long-term 3.8 per cent average.

Even UBS’s Matt Mish — one of the more bearish credit strategists — thinks the default rate for low-grade US corporate bonds will only climb to 6.5 per cent (and 9 per cent for US leveraged loans). And it should be noted that some people think the whole ‘zombie companies’ narrative is overplayed.

Although Swiss Re stresses that defaults are going to rise “beyond the realm of zombie firms”, its economists reckon that an awful lot of corporate undead lurk in supposedly more defensive sectors like consumer staples and healthcare.

Key defensive sectors have been significantly negatively impacted by credit rating downgrades this year, with healthcare experiencing most downgrades. 6 We also find that select defensive sectors have the largest share of zombie companies, significantly greater than for select cyclical sectors (Ed note: 31%).

Possible explanations are that: 1) the financing discipline toward the cyclical sector is stricter; and 2) cyclical companies achieve higher operating profits in times of economic booms to ensure they have enough buffer during downturns, making them more resilient with regards to their interest coverage ratios.

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