Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: a corporate debt binge, a potential taper tantrum, the growth of collateralized-loan obligations, and the rise of zombie corporations. To sign up for the Capital Note, follow this link.
News and Views
The Walking Dead
Japan’s early-1990s financial crisis, which saw the Nikkei stock index fall by more than 60 percent, killed off scores of businesses and financial institutions. But some corporations were kept of life support, surviving despite paltry returns. Rather than let state-owned enterprises go under, Japanese policy-makers pressured banks to provide them with “evergreen” lines of credit, creating so-called zombie corporations — debt-laden businesses with returns below their cost of capital. In a 2006 paper, three economists wrote that “banks often engaged in sham loan restructurings that kept credit flowing to otherwise insolvent borrowers (that we call zombies). Thus, the normal competitive outcome whereby the zombies would shed workers and lose market share was thwarted.”
Zombie businesses played a central role in Japan’s “Lost Decades” of near-zero GDP growth. In the wake of the COVID-19 crisis, some worry the U.S. economy is raising its own zombies from the dead. A story in yesterday’s Wall Street Journal highlights the corporate-debt binge fueled by the economic response to COVID-19:
After a brief spike, interest rates on corporate debt plummeted to their lowest level on record, bringing a surge in new bonds. Nonfinancial companies issued $1.7 trillion of bonds in the U.S. last year, nearly $600 billion more than the previous high, according to Dealogic. By the end of March, their total debt stood at $11.2 trillion, according to the Federal Reserve, about half the size of the U.S. economy.
That torrent of inexpensive money has benefited all types of businesses. It helped cruise operators, airlines and movie theaters weather the pandemic by replacing some lost revenue with cash raised from bond sales. It allowed thriving businesses to stock up on cash and to save money by refinancing older debt. And it permitted companies that were struggling before the pandemic to ease the threat of bankruptcy by issuing new long-term debt.
While the Fed’s emergency measures no doubt mitigated what could have been a much worse recession, it also forestalled the creative destruction that tends to come during downturns:
The question now is whether companies have merely delayed a reckoning. Debt-laden companies withstood last year’s recession far better than many had feared. But it was in many ways a unique shock to the economy, more akin to a natural disaster than a typical recession. For all their current enthusiasm, many CFOs and investors acknowledge that businesses could still be punished in a normal downturn that raises borrowing costs for a longer period and does more serious damage to household finances.
Yields on junk bonds, a measure of borrowing rates for the least creditworthy companies, are hovering below 4 percent, an all-time low. An increase in borrowing costs could spur a wave of bankruptcies, and if Japan’s experience is any indication, the alternative is a secular decrease in job creation and productivity.
The Fed’s Role
Meanwhile, the Fed is reportedly planning to discuss a tapering of asset purchases at this week’s Federal Open Market Committee meeting. In the past, the Fed has said it would maintain asset purchases until it saw “substantial further progress” toward its targets of full employment and 2 percent inflation.
While consumer prices have shown an uptick in recent months, the April and May jobs reports came in below expectation, arguably due to Congress’s extension of enhanced unemployment benefits, slated to expire in September. Wall Street analysts are not forecasting a slowdown in quantitative easing quite yet, but when that day comes, central bankers will have to walk a tightrope, with financial-market stability on one side and policy normalization on the other.
Ben Bernanke’s 2013 announcement of a slowdown in central-bank asset purchases set off the notorious “taper tantrum,” sending U.S. Treasury yields up 35 basis points in two days. As the St. Louis Fed puts it, “both the long-term U.S. bond yields and the foreign exchange value of the dollar relative to other major currencies rose substantially at the time of the press conference, as the surprising announcement led markets to expect a reduction in the high level of monetary stimulus. These price movements made borrowing for consumption or fixed investment more expensive and U.S. goods more expensive relative to their foreign counterparts.”
This time around, the stakes are higher, with the U.S. federal debt having nearly doubled since the 2013 taper tantrum. A sharp increase in borrowing costs could impost fiscal constraints on a government slated to run indefinite deficits.
Around the Web
Among the other effects of accommodative monetary policy is heightened risk-taking in the capital markets. Asset allocators are turning to collateralized-loan obligations:
Diameter Capital, which posted a 24 per cent gain in its main hedge fund last year, intends to use the seed money to structure and sell its first six CLOs, which bundle together risky company loans and use them to back interest payments on slices of new debt, each with different levels of risk and return.
Part of the allure for investors is that the CLO market offers a way to improve returns now that low interest rates have made higher-yielding assets scarce. . . . Total issuance of CLOs in the US this year is running at a record pace around $70bn, according to data from S&P Global Market Intelligence, with the total market now sitting at $770bn outstanding, according to Citi. The bank predicts it will grow to $850bn by the end of the year.
Mark Spehn couldn’t join billionaire Idan Ofer at his seaside villa north of Tel Aviv for a June 8 party to mark the initial public offering of Zim Integrated Shipping Services Ltd. But the 35-year-old Deutsche Bank AG trader still had much to celebrate from his desk in London.
Spehn’s long-shot bet on the once-distressed Israeli shipping company has put the German lender on track for one of its biggest wins since its “Big Short” trades against U.S. subprime securities more than a decade ago. With the world’s 11th-largest container shipping carrier now riding the wave of record-high freight rates, Deutsche Bank’s potential windfall could climb to almost $1 billion.
Even though the term “bubble” is usually pejorative, the right kind of bubble, at the right time, can exert a powerful positive effect on the world. A bubble is an objectively irrational shared belief in a better potential future . . . but that doesn’t just describe someone bidding up asset prices; it also describes anyone who chooses to build that kind of future. (And it’s not a coincidence that the other social sense of “bubble” is a filter bubble — a fact- and criticism-proof barrier that keeps a set of people convinced against all external evidence that they’re right.)
The first big smartphone bubble didn’t show up in stock prices; it was Apple’s conviction that a fully featured, touch-based, internet-connected device could be put in the hands of millions of consumers for a few hundred dollars.
While talk of zombie corporations usually refers to Japan, a paper from the Bank of International Settlements finds a widespread increase in the incidence of such companies across developed economies:
Using firm-level data on listed non-financial companies in 14 advanced economies, we document a rise in the share of zombie firms, defined as unprofitable firms with low stock market valuation, from 4% in the late 1980s to 15% in 2017. These zombie firms are smaller, less productive, more leveraged and invest less in physical and intangible capital. Their performance deteriorates several years before zombification and remains significantly poorer than that of non-zombie firms in subsequent years. Over time, some 25% of zombie companies exited the market, while 60% exited from zombie status. However, recovered zombies underperform compared to firms that have never been zombies and they face a high probability of relapsing into zombie status.
Relevant to the impact of monetary policy:
We find evidence that zombie firms receive subsidised credit. While interest paid relative to total assets is 0.1 percentage points higher for zombie firms, the difference to non-zombie firms is not statistically significant despite their lower profitability and greater riskiness. It would appear that properly taking into account the greater credit risk associated with lending to zombie firms should be reflected in significantly higher interest payments of these firms relative to non-zombie firms.
Zombie companies are significantly more leveraged (measured as total debt as a ratio to total assets), but . . . they shrink their debt, probably reflecting efforts to reduce leverage or difficulties in obtaining sufficient credit despite being kept alive. At the same time, zombies issue significantly more equity than other firms do (relative to total assets).
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