The Covid-19 crisis could be the catalyst needed for the large number of ‘zombie’ companies that emerged after the 2009 financial crisis to be shaken out from the system, but central bank intervention could stop this from happening.
The loss of ‘zombie’ companies - or firms that show little signs of life but manage to survive thanks to cheap borrowing costs – “would free up resources for companies that could use them more efficiently,” Fidelity global head of fixed income research Martin Dropkin said in a white paper.
A number of these firms are rated as investment grade quality on the lowest end of the category (BBB), but are at risk of being downgraded into the high yield market and becoming so-called fallen angels.
JP Morgan Credit Research estimates roughly $215bn of US investment-grade debt and €100bn of European bonds could be downgraded to high yield this year.
In the US, the amount of BBB-rated bonds outstanding now equals around 70 per cent of the entire US high yield market. Dropkin thinks the sheer size of potential fallen angels could overwhelm the market.
Auto maker Ford recently became the largest ever fallen angel as a direct result of the current crisis, after S&P Global Ratings cut its credit rating from investment grade to junk BB+.
Despite these risks, it came as somewhat of a surprise when the US Federal Reserve announced it would be buying high-yield exchange-traded funds (ETFs) as part of its $2.3trn rescue package.
Jim Reid, head of global fundamental credit strategy at Deutsche Bank, said in a note to clients that it was a “huge moral hazard” for fallen angels.
He explained that a lot of BBB-rated companies have seen their ratings downgraded in recent years due to “central bank inspired ultra-low interest rates encouraging them to lever up” and “a related desire to return value to shareholders, especially through share buybacks”.
The package was “the latest instalment of a 20- to 25-year super cycle where the authorities have been so reluctant to see the creative destruction that’s so important to successful capitalism that they had to make another stunning major intervention,” according to the strategist.
Reid argued that ever since the Fed of the late 1990s decided to bail out the financial system after the Long-Term Capital Management (LTCM) collapse, “we’ve had rolling state sponsored capitalism and large moral hazard”.
“This has meant that each subsequent default cycle (or mini market cycle) has been less severe than the free market parallel universe version would have been and has left increasingly more debt in the system as a result and meant that the intervention necessary to protect the system has got greater and greater,” he added.
“In my opinion, it also helps lock in lower productivity as you keep more low/no growth entities alive.”
Fidelity’s Dropkin highlighted the growing spreads between BBB and BB-rated bonds, believing it is a result of the anticipation of an influx of fallen angels into high yield.
He said that the lower rated (B/CCC) companies, particularly European high yield firms, are at risk of being crowded out by the large amount of debt moving into high yield.
The fallen angels will swell the size of the BB category in the high yield index, “forcing managers of both passive and active strategies to reallocate from riskier categories to maintain benchmark constraints,” Dropkin said.
Since fallen angels typically have stronger balance sheets than lower-rated companies, they will find it easier to issue new bonds and exacerbate this shift, he added.
Another concern for bond investors is the threat of leveraged buyouts. Private equity firms are sitting on significant amounts of capital that Dropkin said are likely to be deployed now that valuations are more attractive.
“Existing bondholders almost always lose out in leveraged buyouts as the business model necessitates loading up target firms with freshly issued debt,” he explained.
Despite this he still believes investment grade bonds “are currently trading at very attractive levels, with US bonds especially well positioned”. However, he cautioned that within the BBB category, thorough research is needed to understand issuers most at risk of being moved into high yield.