Pandemic Ushers In ‘Night Of The Living Debt’

The coronavirus crisis and attendant recession are nobody’s “fault”.

That’s a common refrain, and it serves as the justification for myriad government rescue programs aimed at alleviating the acute economic distress that defined the second quarter of 2020.

The idea that no one (and no company) is to “blame” for the pandemic is likewise used to justify heavy-handed intervention in markets on the part of central banks.

No manifestation of that intervention has received more scrutiny than the Fed’s foray into the US corporate bond market.

To be clear, it’s not the “unprecedented” nature of the intervention that has critics up in arms. Central bank corporate bond-buying is nothing new, even if it’s new in the US. Additionally, the size of the Fed’s purchases of corporate bonds and credit ETFs is not large in the context of its balance sheet. Finally, as I’ve variously attempted to emphasize, one explicit aim of the Fed’s response to the financial crisis was driving down corporate borrowing costs. So, while the Fed wasn’t buying corporate bonds directly until 2020, its accommodative policies created a perpetual bid for credit for most of the post-GFC era.

Due in part to those three points, I’ve generally taken a sanguine view of the Fed’s corporate bond-buying program as a concept. However, regular readers know that I’m as incredulous as the next guy/gal when it comes to just how powerful Jerome Powell’s promise to backstop the corporate credit market has been.

Clearly, it was not desirable for large, blue-chip US companies to be shut out of capital markets due to a virus. Given that, I would argue that the idea of a Fed backstop for the market was a good one under the circumstances.

That said, you’d be forgiven for suggesting that the Fed has been too successful. Investment grade corporate bond funds have enjoyed 18 consecutive weeks of inflows on Lipper’s data, for example. High yield funds have similarly enjoyed almost uninterrupted investor demand.

This has led directly to massive corporate supply. The most creditworthy corporate “citizens” (e.g., Apple, Amazon, and Google) are essentially borrowing for free. 2020 topped 2019 for total IG supply nearly two months ago, when issuance exceeded $1.13 trillion. Market participants now expect August’s offerings to push the total amount of blue-chip debt sold this year beyond the all-time, full-year record set in 2017.

And it’s not just investment grade borrowers. As documented in “Junk. Lots Of It“, 2020 exceeded all of last year for high-yield sales this week, after Tuesday’s deals drove total junk issuance to nearly $275 billion for the year.

If you read every post in these pages (which you should, by the way, because I don’t do “filler” — if it’s here, it’s notable), you’re familiar with all of the above, including the latest stats on 2020’s corporate debt binge.

The problem — and this is where the Fed has arguably been “too successful” — is twofold.

First, corporate America came into the pandemic over-leveraged on many metrics. All the new debt just exacerbates the situation. It doesn’t help that much of the debt taken on in the post-GFC era was incurred in the service of financial engineering (e.g., borrowing to fund share buybacks).

Second, many fear that the real, long-term damage to the US economy from the pandemic is yet to be realized. If earnings and corporate cash flows do not recover as quickly as expected due to structurally higher unemployment, permanently depressed demand, and/or virus-related changes in consumer preferences, the debt incurred in 2020 may end up being largely unserviceable.

That raises the specter of a figurative “zombie” apocalypse, where the ranks of the corporate undead multiply.

Read more: Albert Edwards Predicts Zombie Apocalypse

The scope and character of this potential problem is unique to the current downturn, even as the “zombie company” phenomenon is not new.

In a note dated Friday, BMO’s Daniel Krieter and Daniel Belton write that in contrast to previous recessions, “corporate debt issuance skyrocketed in the first of half of 2020 as corporations used debt to plug the hole of lost earnings arising from the pandemic”.

As noted above, this year is poised to easily break the all-time record for investment grade supply, and it took just eight months for junk borrowers to tap the market for more than they accessed in all of 2019.

“Naturally, the explosion of corporate debt supply was made possible by the extraordinary intervention of the Fed”, Krieter and Belton go on to say, before noting that “while these actions saved many viable firms from insolvency, they also created the perfect breeding (feeding?) ground for the proliferation of zombie companies”.

The figure shows the percentage of US companies whose interest expense outstrips profits (BMO uses trailing 12-month EBIT).

Considering the massive debt issuance outlined above, the number of zombies will multiply in the months ahead, especially as earnings collapse.

In the figure below, Krieter and Belton use Q2 results on the way to calculating that 37% of companies “failed to generate sufficient operating profit to cover interest expense during the second quarter”.

They do say that Figure 7 probably overstates the case considering Q2 likely marked the trough for earnings, but the point is simply that an environment characterized by exploding debt issuance and imploding profits is, as they put it, “a perfect breeding ground” for zombies.

As far as the Fed’s role, they leave little room for doubt. “The growth of zombie corporations can be tied directly to increasing Fed intervention during the past thirty years”, BMO says.

Going forward, it’s possible that the ranks of the living dead (or “the living debt”, as they call it) will grow. “Any second [virus] wave in the fall that would result in still-low earnings and continued heavy debt issuance would only exacerbate the proliferation of zombies”, Krieter and Belton caution.

Now, who’s hungry? Because Apple will feed you a 40-year tranche for a “juicy” +188.

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