This is the transcript of my podcast last Sunday, THE WOLF STREET REPORT. You can listen to it on YouTube, and you can find it on Apple Podcasts, Spotify, Stitcher, Google Podcasts, iHeart Radio, and others.
Through the first half of August – which is normally a quiet period for the bond market in the US – a total of $56 billion in junk bonds and leveraged loans were issued by junk-rated companies, according to S&P Global. That was nearly 50% higher than the prior records for the same period in 2012 and 2016, and more than double the amount issued in the entire month of August last year.
The Fed’s announcement on March 23rd that it would start buying corporate bonds and bond ETFs set off a huge rally in the bond market, including in the junk-bond market.
The rally started before the Fed ever actually bought the first bond. And then the Fed hardly bought anything by Fed standards. Through the end of July, it bought just $12 billion in corporate bonds and bond ETFs, including a minuscule $1.1 billion in junk bond ETFs. It’s not even a rounding error on its $7-trillion mountain of assets.
But the announcement was enough to trigger the biggest junk-debt chase in the shortest amount of time the world has likely ever seen. And it kept the zombies walking, and it generated a whole new generation of zombies too.
The junk-bond ETFs the Fed dabbled in hold junk-bonds issued by companies that have been taken over by Private Equity firms in leveraged buyouts, where the acquired company itself borrows the money to pay for its own acquisition. Leveraged buyouts produced the first big wave of bankruptcies among retailers that started years before the Pandemic, and included Toys R Us, now liquidated.
The junk bond ETFs that the Fed has bought hold these types of bonds, including bonds by PetSmart, which was taken over in a leveraged buyout by private-equity firm, BC Partners.
In the second quarter, companies that had been taken over by private-equity firms issued over $31 billion in junk-bonds, the highest level since 2014, according to Dealogic. The third quarter is on the same track: In July, companies owned by private-equity firms issued $10 billion in junk bonds.
And it goes far beyond private equity firms.
Carnival, the largest cruise-ship operator, with a deep-junk credit rating of triple-C, and whose revenues collapsed to near nothing as all its cruises have been canceled, while the restart of its cruises gets pushed out further and further, well, in early August, it sold its third bond issue since the Pandemic: $900 million in junk bonds, with a yield of nearly 10%.
Royal Caribbean, the second-largest cruise-ship operator, issued $3.3 billion in junk bonds in May.
The collateral for these cruise-line bonds? Cruise ships, among other things. But the value of these cruise ships today is very hard to ascertain, beyond scrap value, because until cruises are back in full swing, whenever that may be, if ever, cruise ships are just a huge expense.
Cruise lines are now burning cash day after day, and they’ll continue to burn cash for months if not years, even after they start operating again, and they’re piling on mountains of debt in order to raise cash that they’ll burn before they’ll ever start operating again.
If they weren’t zombies before the Pandemic, they’ll be zombies going forward.
This borrowed cash will be gone, and the debt will remain, and they won’t be able to get rid of this debt and trim it down unless they restructure it, either in bankruptcy court or outside of bankruptcy court, by transferring all or much of the equity to creditors, with shareholders getting wiped out, or mostly wiped out, and some creditors taking big losses too.
But instead, they got bailed out, and they were turned into zombies, and a whole new generation of zombies was born that will add to the number of existing zombies.
For investors, a restructuring would be ugly. But for the cruise lines, it would be a great thing. They’d be smaller and nimbler and they’d be more able to invest, and they could move forward. But no. Instead of allowing this to happen, they were turned into zombies.
With this strategy of bailing out and pumping up the corporate credit market, and particularly the junk-bond market and leveraged-loan market, the Fed made it possible for corporate zombies to raise new money from investors and become even bigger zombies, rather than being restructured and cleaned up. And it’s causing a whole new generation of zombies to be born.
And their over-indebted balance sheets are now clogging up the economy and productivity and future economic growth.
Even the Bank for International Settlements uses the term “zombie.” Zombie companies, as the BIS defines the term, are unable to cover debt servicing costs from current profits over an extended period, and they end up having to borrow money to pay interest on existing debts.
Zombies are over-leveraged very risky companies with a business model that is not self-sustaining – meaning it needs to constantly raise new money from new creditors to pay existing creditors.
That’s OK for young companies that may not have a product yet, and may not have sales yet, or are just starting to get sales and they’re ramping up – though generally, at that level, equity financing rather than debt financing is the choice here.
But once a company has been around for years, has thousands of employees, and billions of dollars in assets and liabilities, in theory, its business model should be such that its revenues should cover all operating expenses plus interest.
Back in the late 1980s, less than 3% of the companies listed on US stock exchanges were zombies, according to the BIS. By 2018, 19% were zombies, including just about the entire shale oil and gas sector, much of which is now in bankruptcy court or heading that way, or emerging from it.
This is the condition companies were in when they walked into the Pandemic.
The BIS found that the rise of the zombies is linked to reduced financial pressure, meaning easy money forever. The BIS study also found that zombie companies are less productive and crowd out investment in more productive firms.
Often, zombies are already marked by a junk-rating. Their operating cash flows are thin and insufficient to pay for interest expenses, and they have to borrow money to keep going. If they cannot get new funding, they’ll have to default on existing debts.
The hope for creditors is that these companies can always issue new junk bonds or leveraged loans to service existing debts, thus paying existing creditors with money raised from new creditors.
Some junk-rated companies have been able to issue bonds in the United States in recent weeks at yields below 3%. These companies have a relatively high probability of default, and they will need to borrow more money in the future, or else they will default, and investors are lending them money at record low yields that for now barely beat inflation, and leaves almost nothing to compensate them for credit risk.
S&P Global and Moody’s are forecasting that the default rate for junk-rated US companies will exceed 12% in early 2021. But the market doesn’t care. The market thinks these companies will never default.
And they won’t default if they keep getting new money to burn.
The whole fracking industry was founded on that principle:
Increase oil production at astounding rates, burn cash forever, and borrow more and more money to fund the cash burn, and as long as markets kept funding the cash burn, it worked out.
But then, one day, the market opened its eyes and saw that the companies now had a huge amount of debt and not nearly enough cash flow to fund the interest payments or even operating expenses without more borrowing, and the market grew skittish, and when it grew skittish, funding dried up, and then these companies tumbled into bankruptcy one after the other, hundreds of them by now.
This was based on the time-honored principle that something works, until it doesn’t.
Short-term rescue interventions by governments or central banks during a sudden crisis, such as the Pandemic, are one thing, particularly if they support the unemployed, but also if they unfreeze credit that had frozen up even for healthy companies.
But when these rescue efforts become long-term conditions where zombies are being propped up, and where more and more zombies are being created, and where existing zombies become even bigger zombies – that’s quite another thing.
And that’s precisely what has happened after every bailout. It led to long-term easy money and constant stimulus, even during the Good Times, that kept the zombies walking and multiplying, no matter what.
This happened after the Financial Crisis too. Zombies were kept walking, and during the Good Times, they weren’t restructured as interest rates remained low, though the Fed raised them timidly starting in 2015, too little too late, and though the Fed began to unwind its QE holdings in 2017, too little, too late.
And as soon as the slightest quivers when through the credit markets in 2019, the Fed did a U-turn on interest rates and stopped its QE unwind and then rolled out the repo-market bailout.
So when the Pandemic came, there was a huge amount of risk already piled up, and an enormous record-breaking amount of corporate debt, and the economy was crowded with zombie companies running around.
And the Fed with its bailout programs made all of those problems worse. It tries to eliminate the risk of loss of investors, and it keeps bailing out the riskiest companies, instead of letting the companies restructure in bankruptcy court, shed their debts, make investors eat their losses, and move on in nimbler more productive form.
Without this self-cleansing process, capitalism can no longer function. Risky things need to be allowed to blow up, investors need to be allowed to take losses, and yeah, markets need to be allowed to go wild, which reminds investors in the future to be more prudent.
These processes see to it that capital is allocated based on risk and productivity, and that unproductive cash-burn machines are restructured or dismantled so that they don’t clog up the economy.
Without that function, the economic system bogs down, stuffed with zombies that are hobbling from bailout to bailout, never really restructuring their debts and making investors take the losses. Easy money is a curse for capitalism.
* * *
You can listen to and subscribe to THE WOLF STREET REPORT on YouTube and you can find it on Apple Podcasts, Spotify, Stitcher, Google Podcasts, iHeart Radio, and others.