If the Fed Saved the Day, Why Is There a Fear of ‘Zombies’?

(Bloomberg) -- It might be the most successful central bank intervention in history: Without doing much more than issuing a press release, the U.S. Federal Reserve turned a pandemic-driven credit crisis into a record-breaking flood of lending. So why are so many investors worried? Some fear that the Fed has merely traded a liquidity crisis now for a solvency crisis later. Others think that the new debt boom, layered on top of a decade of hefty Fed-fueled borrowing, will produce so-called zombies -- firms surviving on endless debt that are lifeless when it comes to economic growth.

1. What do you mean by liquidity and solvency?

For corporate borrowers, liquidity means the ability to find the cash needed to pay debts, either out of their own revenue stream or in the credit markets. Solvency means not having debts that are too big to repay. Companies can go under if they lack either one. Borrowing new money to pay off old debts because you’re short of cash is how liquidity problems can become solvency problems.

2. Is that what the Fed did?

Looked at one way, yes -- it helped companies, some that were dangerously weighed down with debt and others that won’t be profitable for a while, stay afloat by adding more debt. Looked at another way, though, the Fed prevented panic over the pandemic’s economic disruption turning into a global financial meltdown. Its announcement that it would aid big companies by buying short-term loans known as commercial paper, a wide range of corporate bonds (including some that had recently been downgraded to junk status) and bond exchange-traded funds (ETFs) triggered a 180 degree turn in market sentiment for most types of credit. The central bank’s credit backstop for larger companies is split into a $500 billion program to buy new debt and another $250 billion secondary facility to purchase bonds already existing in the market and exchange-traded funds that include investment-grade and junk bonds.

3. What was the result?

Investment grade bonds are selling at a record pace: Issuance topped $1 trillion by late May, the fastest pace ever, while junk bond supply also soared. Given the stepped-up pace, corporate net debt could increase anywhere from $500 billion to $1 trillion this year, according to BI analyst Noel Hebert. Even some of the businesses hardest hit by the pandemic are easily raising debt to build a cash war chest. Carnival Corp. and Norwegian Cruise Line Holdings Ltd sold bonds secured by boats and islands to eager investors. Airlines that grounded planes and canceled flights are shoring up liquidity. Delta Air Lines raised more than $10 billion since March, including from a bond sale and two term loans, then returned to the bond market weeks later with a five-year unsecured offering. Hotels that have seen occupancy tumble are binging on debt as well. Bank of America Corp. analysts forecast that investment grade companies will add about 1.3x and 0.9x to gross and net leverage by the fourth quarter of this year.

4. Will that meet companies’ needs?

Nobody knows, since it’s unclear what course the pandemic will take. A quick discovery of a vaccine or a robust recovery after the end of lockdowns would boost bottom lines, while a big second wave of infections could drain them. So many companies are borrowing as much as investors are willing to lend them, often by drawing down the revolving lines of credit offered by their banks and convincing their lenders not to enforce so-called covenants. Vail Resorts Inc. was granted a two-year reprieve on a key performance measurement by banks that allowed the resort operator to then raise $600 million of financing.

5. So what’s the problem?

For one thing, the Fed may have merely delayed a huge wave of bankruptcies -- and those business failures could be more painful down the road because companies in the interim have added debt and burned through cash. (On the other hand, delaying bankruptcies may have been the equivalent of “flattening the curve” for the virus -- avoiding a peak that could overwhelm courts and markets the way ICUs were in danger of being swamped.) Another outcome, possibly more dire, is that moribund companies kept alive by central bank largess become what economists call zombies.

6. That sounds ... bad?

Even before Covid, a decade of easy money and low interest rates had already boosted the number of zombie firms, according to academic research (Adalet McGowan et al 2017). The term zombie was coined to explain the “lost decade” in Japan of the 1990s. The definition of zombies differ but for the main they are companies with unsustainable balance sheets that don’t earn enough to cover interest payments. Economists and Wall Street analysts expect the count of the walking-dead to increase.

7. What harm do they do?

Zombie firms have less capital to make investments and acquisitions and are less able to grow. At the same time, by hanging on they can block the rise of healthier competitors. A handful of zombies can blight entire industries, making a surge in their ranks one of the biggest worries for a robust economic recovery.

8. What are the options?

To some, there’s not much the Fed can do about this now, since companies have already piled on debt following the central bank’s vow to backstop markets. Others argue for the Fed to take a different path. In a March 24 letter to Congress, 200 academics, led by Stanford University Graduate School of Business Professor Jonathan Berk, called lending programs aimed at corporations “a huge mistake.” Better to focus help directly on people living paycheck to paycheck who lost their jobs, it said. Policy makers, however, are gambling that if they prevent bankruptcies, they are also improving employment prospects. The thought is that companies kept alive on liquidity respirators will return to health and hire back workers.

The Reference Shelf

• A Bank of International Settlements paper on zombie firms.
• The OECD looked at the impact of zombies on productivity.
• An article on whether the Fed’s corporate debt purchases are emboldening more risky borrowing.
• Some companies are using the Fed intervention to boost their cash position while cutting thousands of jobs.
• The debt boom is also putting big companies in position to get bigger.

©2020 Bloomberg L.P.