This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to S&P Global Market Intelligence.
By some accounts and by some measures, high-yield investors need to brace for an attack of the zombies. In financial parlance, zombies are the walking dead of the corporate world, companies saved from default only by the Federal Reserve's current practice of quantitative easing on steroids. The question we address this week is, "How great a horror show do the living dead bond issuers pose in reality?" (See note 1).
Background
Financial journalist and author John Authers recently wrote about an economic conundrum: Over the past 15 to 20 years, default rates have been low by historical standards, even as economic growth has trended lower. "The biggest explanation is that, over the last 20 years, the authorities have implicitly and explicitly intervened to lower defaults. … In short, we've moved away from creative destruction and towards an economy with a higher percentage of zombie companies" (see note 2).
As an aside, economist Joseph Schumpeter defined "creative destruction" as "the process of industrial mutation that continuously revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one." (see note 3) The term applies rather imperfectly to debt-induced bankruptcies in which the debtor settles with its creditors for pennies on the dollar and goes on operating much as before.
Authers suggests that permitting more companies to default would benefit long-term economic growth. It is difficult, however, to see how GDP gains are enhanced by companies entering Chapter 11 and then exiting, often only to file a second or third time. Companies that simply shed debt courtesy of the Bankruptcy Code do not withdraw from the marketplace in favor of more up-to-date and efficient innovators. The herd does not grow fitter in the absence of genuine culling. In short, promoting a higher default rate, as opposed to a higher corporate extinction rate, will not necessarily elevate economic growth.
MORE FRIDSON: Sharp credit quality upturn projected for high yield in 2021
The day before Authers' piece appeared, Katherine Doherty and Tom Contiliano chronicled a zombie attack in the equity market (see note 4). They supplied a technical definition for "zombie" as they reported that 726 companies in the Russell 3000 index failed to cover their interest payments with operating earnings over the preceding 12 months. Doherty and Contiliano described such a deficiency as "a red flag to pros." They further noted that the zombies were up by an average of 30% year-to-date versus 13% for the full index, with 41 of the living dead up by 100% or more.
Finally, as noted in "High-yield conference panelists weigh in on risks and opportunities," the speculative-grade bond market's dawn of the dead came up in the June 7-10 CFA Society New York High Yield Bond Conference. To quote ourselves, "Panelist (John) Dixon opined that some zombie credits will resume trading at distressed levels once the Fed ceases its unprecedentedly forceful market support." In light of Doherty and Contiliano's report that nearly a quarter of Russell 3000 companies currently satisfy their zombie definition, one might expect a massive default wave to engulf the high-yield universe once the Fed reverts to a normal monetary regime.
The less cataclysmic case
One reason to temper high-yield default rate expectations, notwithstanding the reputedly large population of zombies, is that the Doherty/Contiliano-cited estimate amounting to nearly 25% of Russell 3000 companies is based on trailing-12-months coverage numbers. That period includes the mid-to-late-2020 aftermath of the economic plunge that triggered the Fed's QE-on-steroids response. Corporate earnings were still quite depressed at that time.
Note as well that many Russell 3000 companies are not high-yield issuers. The ICE BofA US High Yield Index currently contains debt of only 923 issuers. Keep in mind, when considering all corporate universes different from the high-yield index's members, that bankruptcies by asset-lite tech companies that went public before reaching GAAP profitability will not, by and large, affect high-yield default rates.
A forward-looking assessment that focuses on high-yield issuers produces an unalarming picture. At our behest, specialists at Bloomberg performed an analysis in which zombies were defined as issuers within the Bloomberg Barclays US Corporate Index with trailing-12-month EBITDA/interest ratios of less than 1.0x. The analysts identified 92 such issuers as of year-end 2020. They then calculated how many zombies the index would contain at the end of 2022, based on consensus EBITDA forecasts reported by Bloomberg. Contributors of those forecasts include both sell-side equity analysts and independent research providers. That exercise turned up a grand total of one issuer.
Some market participants may find it hard to accept the possibility that the high-yield universe contains very few bona fide zombies. After all, the distress ratio — the percentage of issues in the ICE BofA US High Yield Index with option-adjusted spreads-versus-Treasuries of +1,000 basis points or greater — was just 2.48% on June 15. That compares with a December 1996-December 2020 monthly median of 9.81% and a mean of 13.80%. With high-yield risk premiums far below the levels ordinarily seen in conjunction with economic indicators, lending standards, and Treasury yields comparable to today's, it seems on the face of it that there must be many issues that deserve to be trading at distressed levels but are not.
To test that proposition, we employed an alternative definition of zombies that does not involve interest coverage ratios. We found that on Dec. 31, 2019, before COVID-19 threw the economy into a tailspin, the ICE BofA US Distressed High Yield Index contained bonds of 79 issuers with aggregate amount outstanding of $60.2 billion. On June 15, the comparable figures were 38 issuers and $35.3 billion. Eleven issuers that ceased to be represented in the distressed subindex disappeared from the ICE BofA US High Yield Index altogether, whether by default, retirement, coming to within one year of maturity, or, seemingly unlikely, upgrading to investment-grade. That left 33 issuers that were distressed at the end of 2019 but are currently included in the ICE BofA US High Yield Index's nondistressed subindex.
The 35 year-end 2019 distressed issuers that remain distressed cannot properly be called zombies; their precarious financial condition is clearly flagged by the market. Among the 33 now viewed as nondistressed by the market, however, some are projected to be in worse shape in 2022 than in 2019, based on Bloomberg-consensus forecasts of EBITDA margin. We believe that if a company was distressed when the economy was in reasonably good shape and is expected to be less profitable when the economy regains its stride, that company is a prime suspect for returning to the distressed category, and possibly defaulting, when the Fed takes off the training wheels.
Consensus forecasts of EBITDA margins are available for slightly more than half (17) of the 33 potential zombies. No such forecasts are available for private issuers of public bonds. Nine of the 17 are projected to have lower EBITDA margins in 2022 than in 2019. Let us call it a 50/50 split between higher and lower projected EBITDA margins for the issuers on which projections are available. Applying the 50% ratio to the 16 issuers for which no projections are available generates another eight presumed zombies. That brings the total to 9 + 8 = 17, or 1.9% of the issuers in the ICE BofA US High Yield Index's issuers.
The nine zombies we can specifically identify on the basis of EBITDA margin forecasts have an average of $452 million face amount outstanding. Assuming the same average for the other eight produces an estimated face amount of zombie debt of $7.7 billion for all of the 17. That equates to 0.5% of the ICE BofA US High Yield Index's total face amount.
In round numbers, therefore, we estimate that at present there are 17 zombie companies in the high-yield universe with a combined $8 billion face amount outstanding. It amounts to small potatoes in the context of a $1.5 trillion market.
Investment conclusion
Conceivably, the sell-side analysts contributing to the consensus EBITDA margin forecasts have an optimistic bias, even two decades after an investigation led by Eliot Spitzer focused attention on potential conflicts of interest arising from investment banking relationships. If so, our count may understate the zombie count to the extent that some of the 16 companies that migrated from the distressed to the nondistressed subindex, but are currently projected to have higher EBITDA margins in 2022 than in 2019, really ought to be projected to be less profitable next year than two years ago.
In addition, panelists at the abovementioned high-yield bond conference pointed out that some energy issuers that avoided default only by the grace of crude oil's surge from -$37.63/bbl on April 20, 2020, to $69.96 on June 9, 2021, the date of their session. (Our metric in this instance is the Generic 1st Crude Oil, West Texas Intermediate contract.) It is not beyond imagining that OPEC will decide to take another crack at bankrupting every single U.S. fracker. That, however, is a perennial risk distinct from the general zombie phenomenon.
To be clear, we certainly expect the distressed universe to expand by more than 17 companies when the next recession approaches. (As a point of reference, the ICE BofA US Distressed High Yield Index's issuer count rose from 97 in December 2019 to 312 in April 2020.) That, however, is an entirely separate question. The 17 zombies identified by our analysis are the companies that the market identified as troubled even when the economy was doing well, prior to the COVID-19-induced downturn, and are expected to be in even worse shape when the economy is once again humming along in 2022.
In summary, no portfolio manager wants to get bitten by a metaphorical zombie of the financial variety when monetary policy returns to normal. By our reckoning, however, the high-yield picture is nowhere near as scary as those movie scenes of marauding mobs of real-life zombies.
Note: The discussion of high-yield fair value models that we promised in our June 15 piece will appear next week.
Research assistance by Bach Ho and Ducheng Peng.
ICE BofA Index System data is used by permission. Copyright © 2021 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann Livian Fridson Advisors LLC's use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.
Notes
1. If you are less worried about the corporate variety of zombies than the real kind, see a complete list of the best and worst states for surviving a zombie apocalypse, from No. 1 North Dakota to No. 50 New Jersey.
2. John Authers, "Zombies are on the march in post-Covid markets," Bloomberg News (June 15, 2021).
3. Joseph A. Schumpeter, Capitalism, Socialism and Democracy, London: Routledge (1942), pp. 82–83.
4. Katherine Doherty and Tom Contiliano, "Zombies defy bankruptcy logic amid meme-driven rally," Bloomberg News (June 14, 2021).