The Federal Reserve has written about “zombie companies.”
**There is no formal definition of a zombie firm, but it is generally agreed that these firms are economically unviable and manage to survive by tapping banks and capital markets. Accordingly, we identify zombie firms in U.S. data by requiring that they are highly leveraged and unprofitable.**
**More precisely, we require that zombie firms have leverage above the sample annual median, interest coverage ratio (ICR) below one, and negative real sales growth over the preceding three years.4 High leverage and low ICR help identify firms that cannot cover their debt-servicing costs, while negative sales growth identifies firms with low growth prospects, as sales growth is a good predictor of firms' future performance....**
**Between 2015 and 2019, our filters select roughly 10 percent of public firms and five percent of private firms as zombies. For listed firms—for which balance sheet data are available—we also estimate that the share of firms in zombie status in 2020 remains in the single digits despite the severity of the COVID-19 recession....** [end quote]
The Fed literally shoveled free money toward corporations during the Covid-19 crisis in 2020. For a detailed description, read “The Lords of Easy Money.” The Fed’s purchases of weak corporate debt (lower rated investment grade and also “fallen angels” that used to be investment grade but were hit by the Covid recession) to keep zombies afloat were prohibited in past years but done in 2020 as an emergency measure. The tsunami of free money (negative real rates) is simply breathtaking.
I have been worried that rising interest rates would cause bankruptcy of zombies that are dependent on rolling over maturing debt at super-low rates. Apparently the Fed is also worried since they have created a new metric, the Corporate Bond Market Distress Index, or CMDI. I will add this to the Control Panel, along with the Financial Stress Index.
**New Fed Tracker Shows Rising Strains in Corporate Debt**
**Gauge indicates pressure on investment-grade corporate bonds, though it remains far below levels hit in crises**
**By Matt Grossman, The Wall Street Journal, June 30, 2022**
**A new Federal Reserve gauge is showing moderate but rising signs of distress in trading of high-quality corporate bonds, reflecting investor jitters about a slowing economy. The first snapshot, offered Wednesday, shows greater strain for the roughly $5 trillion market for U.S. investment-grade corporate bonds, compared with historically low levels in newly released back-looking data from late last year....**
**The CMDI tries to measure that kind of distress in a single number. It comes from a formula combining information about relative bond prices, trading rhythms and new debt sales by companies, along with other factors....**
**The CMDI also has signaled broader economic troubles in the past, with higher index values tending to precede lower industrial production and higher unemployment a year later....** [end quote]
Safe Treasury yields are rising. Bond investors are concerned about corporate debt in a rising interest rate environment with a recession growing more probable. The new gauge shows that the investment-grade corporate debt market is showing “friction.” Investors are losing interest in buying these bonds so they are getting harder to sell – less liquid.
During the 2008 financial crisis, bond markets locked up. Nobody wanted to buy. In October 2008, I bought 10-year TIPS yielding 3% over the rate of inflation on the secondary market. This was unheard-of before or since.
Let’s look at the investment grade and non-investment grade spreads over Treasuries and also the CMDI and Financial Stress Index.
The CBMD Index (Corporate Bond Market Distress Index, New York Fed) shows investment grade major peaks in 2008, 2009 and 2020. Minor peaks in 2012 and 2016. The gauge for investment grade debt is climbing fast at this time, faster than the high-yield bond line.
The St. Louis Fed Financial Stress Index measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. It shows monster peaks in 2008 and 2020 so it’s a great indicator of a financial crisis. The minor peaks are not as distinct as the CBMD index. Currently, the Financial Stress Index is extremely low. It doesn’t capture the stress in the corporate bond market at all.
The ICE BofA Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The Corporate Master OAS uses an index of bonds that are considered investment grade (those rated BBB or better). This chart shows similar data to the CBMD Index and also extends back to 1997, showing the gradual increase of stress in 2002, after the dot-com bubble popped.
Junk bond spreads are climbing, too. The CBMD Index shows how investment grade bonds are showing a faster spread increase than junk bonds.
The CBMD Index is interesting from a stock-market as well as a bond-market aspect. Many people buy index funds which include companies that are rated investment-grade. If the bond spreads of these companies increase they may have trouble funding ongoing activities. Further Fed tightening may drive some investment-grade companies into junk status and may drive zombies into bankruptcy.
The Fed says that 10% of listed companies are zombies. Indexes that include these companies may be hit hard if they can’t borrow.
If the bond market freezes in another crisis the Fed may have to step in.
METARs have seen many cycles come and go. Mungofitch mentioned in one of his many posts that investors need to be able to distinguish a cycle from a trend.
The trend of declining interest rates from the Fed has held since 1980, despite the many cycles overlaid on it.
Perhaps the Fed has finally realized the fragility it has caused in the financial system by suppressing interest rates.
Fed Chair Jerome Powell has said that the Fed will try to target a neutral fed funds rate that neither stimulates nor slows the economy. That would be a true trend change. The markets haven’t seen a neutral Fed since 2000 and possibly since the 1970s.
Will the Fed finally step back and let the free market determine yields? That may be difficult to accomplish since private equity firms have loaded many companies with incredible burdens of low-yielding debt that could sink them in a truly free market.