The 'zombie' problem: Low interest rates and 'leveraged loans' sustain a vast number of lousy companies which should have gone to the wall years ago

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  • 12% of all companies globally are now “zombie firms,” meaning that they can barely pay the interest on their debts, according to the Bank of International Settlements. 16% of US companies are zombies.
  • In the early 1990s, the zombie rate was just 2%.
  • But low interest rates and investor demand for “leveraged loans” have created a huge market keeping afloat lousy companies that should have gone to the wall years ago.
  • Leveraged loans are a $US1.6 trillion risk to global financial stability, according to former Fed chair Janet Yellen.

LONDON – 12% of all companies globally are now “zombie firms,”according to the Bank for International Settlements, meaning that their profits are lower than the interest payments on their debts, and they are more than 10 years old.

When a company cannot make enough money to cover even the interest on its loans (let alone the underlying principal) it is close to bankruptcy. But companies can stagger along for years – like zombies – as long as banks with low lending standards continue to extend them credit.

In the US, the situation is even worse, according to data from BIS published this month. More than 16% of all American companies are zombies. Twenty years ago, in the late 1980s, the zombie problem was negligible, according to BIS senior economist Ryan Banerjee. Only 2% of firms were zombies. BIS’s data covers all companies in Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. BIS is often described as the central banks’ central bank.

It is difficult to estimate how many companies are affected. There are about 43,000 “listed” companies worldwide, according to the World Bank, but many millions more in the unlisted private sector.

These charts from BIS show the relentless rise of the zombies:

Zombie firmsBISThe ‘broad’ definition of zombie firms is a company whose profits are the same as, or less than, its interest payments. The ‘narrow’ definition is a company with a below average ‘q ratio,’ meaning that the cost of replacing a firm’s assets is more than its market cap.

The data is disturbing in light of the threat that “leveraged loans” pose to the global economy: $US1.6 trillion in risky, low-quality corporate debt that will be potentially downgraded, triggering a possible mass sell-off, if interest rates rise.

While companies that are carrying leveraged loans are not the same as zombies, the average “interest coverage ratio” of leveraged loans is heading toward zombie territory. The ratio is a measure of the amount of interest a company must pay compared to its earnings. If the ratio is 1, it means a company’s profits are equal to its interest obligations. Anything below 1 means the company is unable to pay the interest on its debt.

Since 2014, the average interest coverage ratio in leveraged buyout loans – a common form of leveraged loan – has declined by 17%, from a high of 3.37 to 2.79 this year, according to LCD, S&P Global Market Intelligence:

Interest coverageLCD, S&P Global Market Intelligence

In Europe most companies had investment grade credit at the turn of the century. Now, most don’t.

You can tell that zombie debt is junk debt by looking at this next chart, from another recent BIS research paper. Since the year 2000, the quality of debt ratings across all companies has collapsed in the US, Great Britain, and Europe. American debt was always poor quality – the junk debt revolution started there in the 1980s, after all. But in Europe and the UK most companies had investment grade ratings at the turn of the century.

Now, most don’t:

Zombie firmsBIS

So why are zombies so common today when 20 years ago they barely existed?

Simply, the zombies have gone up as interest rates have gone down. This is somewhat counterintuitive, as low-interest rates should make it easier for companies to pay off their debts. In fact, low rates have caused the exact opposite: They made the loans cheaper to take, so more companies took them. At the same time, investors seeking a high interest “yield” were happy to supply them money because leveraged loans pay higher rates of interest, due to the risk involved:

Zombie firmsBIS

Zombies have increased eightfold since the 1990s

With both supply and demand for leveraged loans increasing, the zombie rate increased eightfold over the years.

Zombies are bad for the global economy because they compete with healthy companies for resources (such as office space or equipment); for investment financing; and they lower productivity generally (if they were any good, they wouldn’t need the loans). They also raise wages by reducing unemployment. That’s a good thing in the short-run. But in the long-run they prolong the time workers spend in jobs that are going nowhere.

They are also a symptom of weakness in the banking system, according to Banerjee. “Weak banks are incentivised to roll lover loans to weak firms, keeping them on life support,” he says. If they don’t roll them over, they lose what little cashflows they have, and they are forced to wipe the loans – marked as assets on their balance sheets – from their books.

Zombie companies are one of the reasons that former US Fed chair Janet Yellen is worrying so much about leveraged loans. These are the companies that will go to the wall in the coming downturn. Going out of business because you can’t make money is bad. Going out of business and leaving behind a ton of unpaid debts is even worse.

“I am worried about the systemic risks associated with these loans,” Yellen told the Financial Times last week. “There has been a huge deterioration in standards; covenants have been loosened in leveraged lending.”

“There are a lot of holes,” she added. “We should not feel the financial stability glass is full.”

Read more on the leveraged loan boom:

This story was originally published on October 28, 2018.

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