What’s a “zombie company”? You may have heard the term in the financial media recently and wondered if it’s something you should be worried about.
A zombie company, in its simplest form, is one that isn’t generating enough income to cover the annual interest payments on its debts. With interest rates so low, these zombies have stayed “alive” by refinancing their debts at increasingly lower rates, or simply tacking on more debt to keep breathing. But with rates rising, zombies may be forced to refinance at higher rates, which could pose problems.
Although the term zombie may spook some investors, we don’t see it as a reason for investors to avoid all corporate bonds. However, there are some things to take into consideration when making investment decisions:
- Zombie companies don’t appear to be much of a risk to the broad investment-grade corporate bond market, but there are some large zombies at the lowest rung of the investment-grade spectrum that may be at risk of being downgraded to the high-yield market.
- The high-yield corporate bond market does have more zombie issues, but that shouldn’t come as much of a surprise. High-yield bonds are called “junk” bonds for a reason—they tend to carry much higher risk in conjunction with those high yields.
The term “zombie company” can be defined in different ways, but for our research we considered all companies in the Russell 3000 Index that didn’t generate enough income to cover their debt service during the past three years. We chose a relatively long time period because companies can have ups and downs in a given year, but if it hasn’t earned enough to cover its interest expense during a three-year period, that should begin to sound some alarm bells. At the end of January 2021, the number of zombies hit a new all-time high.
The number of zombies is at an all-time high
Source: Bloomberg, using monthly data as of 1/31/2021. Zombie companies are defined as those in the Russell 3000 Index (RAY Index) whose average 3-year interest coverage ratio was less than one. Interest coverage ratio was defined as earnings before interest and taxes (EBIT) divided by interest expense.
The surge in zombies is likely due to the interest-rate environment. Given such low borrowing costs—and investor willingness to continue lending to these companies—companies have not shied away from borrowing more and more. Some companies may be borrowing because they need to, using the cash proceeds to fund their operations. Others may be borrowing simply because they can do so cheaply.
The surge in corporate debt poses a risk to these individual companies over the long run, because that debt will need to be repaid or refinanced at some point. That’s likely more of a risk to zombies that are borrowing to stay afloat. However, what matters in the near term is their ability to service that debt—and with rates so low, their actual interest payments are relatively low, even as the amount of debt has risen.