The Death Knell for Zombie Companies Is Coming – Here’s How to Profit

Shah Gilani|October 20, 2022

As if you didn’t know, the Federal Reserve’s continuing to send shockwaves through the market by raising interest rates, and they will likely raise the fed funds rate another 75 basis points at their November 2, 2022 FOMC meeting.

But what you may not know is this: higher rates are already impacting corporate borrowers (especially the largest segment of the investment grade market), high yield borrowers, and companies living day-to-day on leveraged loans.

A lot of publicly traded corporations that have to rollover their outstanding loans just aren’t going to make it. The increased cost of floating debt, paired with higher debt servicing costs, will see many of them default. Hundreds of companies with publicly listed stocks will go bust.

Those of you who have been following along know I’ve been talking about this since August. Bottom line, the piper’s come calling.

But as always, there’s an opportunity waiting for you to make a lot of money on these debt junkies. So let me walk you through it – what’s happening now in the bond and high yield debt markets that you may have missed, what’s going to happen, and how to profit.

A Bad Moon Rises

Back in June, JPMorgan CEO Jamie Dimon warned, “That hurricane is right out there, down the road, coming our way.” He was referring to the dual impact of the Fed’s quantitative tightening and the ongoing shocks of the Ukraine war on global supply chains.

The winds are already buffeting corporate debtors.

In April of 2019, S&P Global reported the BBB rated world of investment grade (IG) bonds accounted for more than 53% of all investment grade rated bonds in the U.S. For reference, AAA is the highest investment grade rating and BBB is only one notch above non-investment grade.

The size of the BBB market back then was $3.2 trillion. Today, estimates show its closer to $3.8 trillion. The entire investment grade market is a little north of $5 trillion, so the BBB crowd is critical to watch.

And because you’re probably not watching, you may not know that the effective yield on BBB issued debt on Dec 31, 2021, was 2.60%, but rose 145% to 6.36% on October 14, 2022, based on Federal Reserve Economic Data, also known as FRED.

The spike in rates is hitting high yield debt, also known as junk, even harder.

In the first half of 2022, high yield (HY) debt issuance fell 78% from the first half of 2021, down to only $61 billion, which is on pace to be the lowest full year volume since 2008.

Then, according to Rifinitiv, in the third quarter of 2022 (Q3 2022), HY issuance fell to $15.7b, down 82% from $85.7b issued in Q3 2021.

Maybe that’s because average coupon rates rose 48% from 5.13% to 7.63% in a year. That’s a big jump.

Think that’s bad? The leveraged loan market got hit even worse.

Leveraged loans (LL) are loans extended to businesses that already hold a significant amount of short- or long-term debt on their books and have a poor credit rating history.

LL issuance Q3 2022 was $125b, down from $296.8b in Q32021. That’s a 59% drop.

Maybe that’s because the average yield on LLs skyrocketed 106% year over year, going from 4.57% to 9.42%.

To make matters worse, on October 7, 2022, Bloomberg saw distressed debt jump 21% in a week, to $246 billion.

Higher rates means a higher chance of defaults. UBS predicts defaults on leveraged loans could rise 9% in 2023, and high yield defaults could go to 6.5%.

Deutsche Bank’s latest corporate credit outlook titled “The end of the ultra-low default world?” has even more distressing news.

While the Bank expects BB rated debt, just below BBB, to see a default rate of 2% in 2023, and single B rated debt to see an 11% default rate in 2023, the real scary number is on defaults. They say defaults on CCC rated debt, true junk, “could soar to 45%.”

And the Fed’s not done hiking rates.

So, What Now?

Corporate debtors are starting to show the stress of higher borrowing costs. The zombie companies, perennial debtors who’ve used cheap money and artificially manipulated low interest rates to keep them alive, are coming up to their expiration dates. That’s why I’m calling them zombies – they look like the walking dead.

These firms are facing higher borrowing costs, in some cases more than 100% higher when they have to rollover maturing debt. But it’s not only the cost of the debt. There are also more covenants being inserted into issues being floated to investors.

Bankers are having a hard time placing HY and LL debt with their institutional clients, and are demanding issuers sign off on increasingly restrictive covenants that protect lenders and investors. That’s something zombie companies haven’t had to do in almost a decade.

In my subscription service, we’re targeting high yield debt for a fall and buying downside exposure to zombie companies that will reward us handsomely when these deadbeats finally die and their stocks get buried.

I suggest you do the same – there’s money to be made on what’s going to be hard times ahead for even the lowest rated investment grade crowd, because hundreds of them won’t be IG for much longer.