Financial Zombies And More – Seeking Alpha

There are major concerns about the amount of debt outstanding in the world.

I have recently written:

"Every class of debt in the US-government, household, credit card, auto loans and student loans-have surged to over $1.0 trillion each, and almost 20 percent of US companies are seen as zombies."

"Zombie companies are defined as firms whose debt servicing costs are higher than their profits but are kept alive by relentless borrowing."

As a consequence, many investment vehicles are prepared to move into the situation. One such group of investment strategies looking for bargains in the space of failed companies are known as strategies for "distressed debt" or "special situations."

These strategies involve making short-term bets on or against the debt of struggling companies, extending emergency corporate loans at higher interest rates to seizing control of damaged but fundamentally viable companies through restructurings.

The numbers tell the story.

Robin Wigglesworth writes in the Financial Times:

"Almost $29 billion has been raised by 31 funds this year But a further 140 funds are currently tapping investors and targeting another $100 billion. If eve half meet their targets, then 2020 will be as notable a period for fundraising as 2008, the previous banner year."

And what is the time frame where much of the action will occur?

Many experts believe that this situation will continue on into 2021 and possibly 2022.

The reason for this is that the federal government has created several schemes to provide the economy lots of money, but this will be running out. Likewise many efforts on the part of the Federal Reserve System.

But Mr. Wigglesworth writes that there are more sophisticated investors waiting to get into this space and take advantage of the disequilibrium that exists now in the economy. For example, Goldman Sachs has a new vehicle, West Street Strategic Solutions, with $14 billion on hand, to "take advantage of the mayhem caused by Covid-19."

The possibilities almost seem unlimited.

Gillian Tett also looks into the existence of zombie companies and the possibility for investors to make money through credit default swaps. Credit default swaps (CDS) are derivative contracts that investors use to insure themselves against default.

As she writes in the Financial Times, the CDS is connected with the ability of creditors to recoup their funds in bankruptcies. A CDS makes an investor whole by paying them the bond's original face value minus its market value.

"When a company goes bust, financiers hold an auction to determine the market price, and the resulting prices offer one guide to what creditors think the company's remaining assets are worth."

Ms. Tett goes on:

"Over the past decade, the average CDS auction prices have moved in a band between 10 and 60 cents on the dollar, but have general been between 30 and 40 cents.

However, nine US auctions conducted in the year to August produced an average price of just 9 cents-and just 2.4 cents if you look at the worst four."

These are remarkably low numbers.

One reason given for this is that in the usual case, troubled companies "stagger on" for a while, but then go under. In the current situation, there has been plenty of money available, thanks to the Federal Reserve, to keep these firms "stagger on" for a longer period of time.

The IMF produced a warning last week about their concerns with the high leverage found in US corporations. The Federal Reserve actions this year have resulted in providing the liquidity needed to extend the life of many organizations, creating many zombies, averting a liquidity crisis.

The fear now is for a solvency crisis.

Joe Rennison of the Financial Times states these three facts about the bond market.

First, in the week ending October 28, investors removed $2.5 billion from funds that invest in US corporate bonds.

Second, the yield spread between junk bonds and US Treasury securities jumped 50 basis points in the past week as confidence in the economy seemed to wane in the light of the new rise in pandemic cases.

Third, two junk bond sales for upcoming weeks were pulled.

Market signals are not on the positive side these days.

The United States financial markets are not in a good place. Public and private debt loads are excessive.

And the economy seems in no position to help reduce the debt load. Year over year, US economic growth was a negative 2.9 percent and the inflation rate was 1.3 percent. The economy hopefully will rise to a zero-rate fourth quarter over fourth quarter this year and will rise to maybe 1.5 percent this year. The expected rate of inflation built into the government bond market is around 1.75 percent.

These are not figures that give one much confidence about the ability of the private - and public - market to carry the debt loads that now exist. If 20 percent of US companies are really zombies, there are reasons to believe that a solvency crisis might be in store for the United States for 2021. And central banks are not the ones to look to for help to resolve a solvency crisis.

The year 2021 may not turn out to be what investors think they might be.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Financial Zombies And More - Seeking Alpha

Reviewed and Recommended by Erik Baquero