With the possibility of high yield default rates not seen since the global financial crisis, firms face weakening demand amidst a higher interest rate environment, with zombie companies the most exposed, suggest analysts at the Swiss Re Institute.
The institute defines zombie firms as those that have been in existence for more than 5 years and with an interest coverage ratio (defined as the ratio of earnings before interest and taxes to interest) below 1 for three consecutive years.
Swiss Re writes, “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 various major headwinds, adds the Institute, the first being that major central banks are upping interest rates to fight persistent inflation, which in turn will have the effect of lowering aggregate demand.
Analysts note that reduced demand in an environment of inflationary recessions means fewer revenues for many companies and thus less cash for zombie firms to pay down their own debt.
Additionally, zombie firms were already struggling to make interest payments when rates were low, say the analysts, higher financing costs will only amplify this challenge. Swiss Re states that 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.
Furthermore, an increase in defaults will likely extend beyond zombie firms, says the Institute, with the US high yield corporate bond spreads suggesting a cumulative five-year default rate of around 35%, assuming a 40% recovery rate.
Swiss Re concludes, “Institutional investors must maintain discipline with regards to their corporate credit portfolio. We find the concentration of unproductive zombie firms is greater within select non-cyclical sectors.
“Allowing for the default of zombie firms is economically astute as it would make way for stronger, more profitable companies.”
