Ochicken investment Bankers agreed in January to underwrite the leveraged buyout of software company Citrix by a group of private equity firms, returns on safe assets like government bonds were paltry. Yield-hungry investors were desperate for a meaningful return, which the $16.5 billion deal with Citrix promised. Lenders, including Bank of America, Credit Suisse and Goldman Sachs, were happy to distribute $15 billion to finance the transaction. Inflation has been transitory, central bankers insisted. Russia had not invaded Ukraine, energy markets were quiet and global economies were growing.
Nine months later, the banks tried to offload debt in a market gripped not by greed but by fear – of stubborn inflation, war and recession. Struggling to find takers, they dumped $8.6 billion of debt at a discount, incurring a loss of $600 million. They are still nursing the remaining $6.4 billion on their balance sheets.
The Citrix fiasco is a particularly glaring example of a broader shift in corporate debt markets. After regaining their inner Volcker, Western central banks are pushing interest rates to levels not seen in 15 years and shrinking their balance sheets. Those who bought corporate bonds during the pandemic to avoid a wave of bankruptcies either sold them or have already done so. All of this is draining the market of cash as investors abandon riskier assets like corporate debt in favor of safe Treasuries, now that these suddenly promise a decent return, observes Apollo’s Torsten Slok, a manager private assets. The result is a fall in corporate bond prices, especially for less creditworthy companies: junk paper yields have climbed to 9.1% in America and 7.5% in Europe, from 4.4 % and 2.8%, respectively, in January (see chart 1).
All of this raises tricky questions about what happens next to the mountain of debt that companies have racked up in recent years (see chart 2). Since 2000, non-financial corporate debt has fallen from 64% of GDP 81% in America and 73% to 110% in the euro zone. (In Britain the share is a modest 68%, about where it was in 2000, a rare point of relief for an otherwise beleaguered economy.) Another $17 billion owed by unlisted companies . How wobbly is this battery?
The credit crisis will not affect all borrowers in the same way. Indeed, seen as a whole, the indebtedness of Western companies seems manageable. We calculate that the earnings before interest and taxes of US public companies are 6.7 times the interest due on their debts, compared to 3.6 times in 2000. In the euro zone, this interest coverage ratio fell from 4.4 to seven in this century. Additionally, some riskier borrowers took on debt at low rates during the pandemic. Only 16% of eurozone junk bonds mature before the end of 2024. In the US, that figure is 8%.
Yet soaring borrowing costs will cause stress in three areas. The first includes companies that have come to rely on less orthodox sources of credit, which are often the ones with the most difficult prospects. The stock of leveraged loans in America, usually provided by a syndicate of banks and non-bank lenders, now matches that of junk bonds, and it has also grown rapidly in Europe. The same goes for the value of private credit, offered by private asset managers such as Apollo and Blackstone. These loans tend to tolerate higher leverage in exchange for high and, more worryingly for now, floating interest rates. Borrowers are thus much more exposed to rising rates. Since this type of debt often comes with fewer conditions, lenders have limited ability to expedite repayment once signs of distress appear.
The second area of vulnerability concerns so-called zombie companies: uncompetitive businesses, kept alive by cheap debt and, during the pandemic, government bailouts. Luckily, by our calculations, Enterprise Undead are relatively rare and generally small in size. We define a zombie company as a company that is at least ten years old and whose interest coverage ratio has been one or less for at least three consecutive years, eliminating fast-growing but loss-making technology companies, pre-revenue companies in industries like biotech, where products take years to get to market, and holding companies with no revenue.
On this definition, we identify 443 active zombies listed in America, Great Britain and the euro zone (see graph 3). That’s up from 155 in 2000, but it’s only 5.6% of all listed companies, responsible for 1.9% of total debt and 1.4% of total sales. Their demise could be a win for the economy, as badly run, low-productivity businesses that panicked about bailouts eventually close, though that would be cold comfort to their employees and owners.
The third and biggest area of concern is companies that are simply unfit rather than walking dead. One way to capture their prevalence is to look at companies with less than twice the interest coverage ratio. That brings you to one-fifth of the total debt of publicly traded US and European companies, or some $4 trillion (see chart 4). Also consider companies whose debts are rated just above junk status. Some 58% of the investment grade non-financial corporate bond market is now rated bbb, according to Fitch, a rating agency. The average yield on these bonds has more than doubled in America over the past 12 months, to 5.6%. Unlike high yield bonds, many of them mature soon and will need to be refinanced at much higher rates.
Since the global financial crisis, many mature companies with low sales growth have taken advantage of cheap credit to take on debt to the precipice of junk status to fund payouts to shareholders. As profits come under pressure and interest charges rise, they face pressure that could lead them to cut employment and investment. And if earnings plummet, which some analysts are beginning to predict as recession fears mount, this funding strategy could push these companies over the edge into undesirable territory. Asset managers whose portfolio mandates force them to favor safe assets could then be forced into sellouts, causing prices to crash and borrowing costs to rise even further.
Most companies operating just above junk status are still far from a downgrade, says Lotfi Karoui of Goldman Sachs. Many of the more volatile high-quality borrowers were downgraded at the start of the pandemic, so the rest are on average more robust. In other words, a nightmare scenario is not inevitable. But it’s no longer inconceivable either. ■