- By John Engle
The coronavirus pandemic has had a profound impact on the financial health of countless businesses in the United States. Yet many of these companies have had little trouble tapping credit markets in spite of both their specific business challenges and wider macroeconomic headwinds, thanks in large part to historic interventions by the Federal Reserve, including an unprecedented move to act as the marginal buyer in the high-yield credit market, as I have discussed previously.
The Fed has succeeded in its objective of keeping credit markets liquid through the crisis, but it has also sown the seeds of future trouble. Indeed, the central bank seems poised to discover that loosening a liquidity tap is considerably easier than tightening it.
Meddling with creative destruction
Companies that are unable to service their debts have the final recourse of filing for Chapter 11 bankruptcy protection. Such "zombie companies" can use the bankruptcy process to preserve good core businesses while sloughing off their unsustainable debt burdens in order to start somewhat fresh. Unfortunately, as the Financial Times reported on Dec. 13, this process has increasingly been disrupted:
"Back in 1929, Treasury Secretary Andrew Mellon advocated the mass liquidation of struggling companies to 'purge the rottenness out of the system'. Foreshadowing Joseph Schumpeter's theory of 'creative destruction', he argued this would be the best way to ensure a recovery...Even beyond the zombie company phenomenon, economists fretted that rising corporate indebtedness in general stunts the ability of companies to invest. These fears have been supercharged in the wake of the coronavirus crisis. Of the many legacies the pandemic will leave in its wake, a monstrous corporate debt burden is one of the biggest."
While a financial purgative akin to Mellon's 1929 proposal was never going to be on the cards for 2020, the idea behind it speaks to a critical feature of corporate finance and business performance in a market-based economy.
Unfortunately, the Fed's meddling in the high-yield credit market has made it possible for many companies that would otherwise have no choice but to accept bankruptcy to instead kick the can down the road by raising even more debt.
A temporary reprieve
When the Covid-19 crisis has passed, the Fed will likely have to roll back many of its emergency measures. There may be painful consequences when it does, as Bloomberg's Paula Seligson discussed on Dec. 3:
"For now, the Federal Reserve is helping these companies limp along by keeping interest rates near zero and forcing investors that want decent returns to consider financing struggling businesses. But money managers won't be willing to lend to weak corporations forever. Companies are trying to just hang on until life returns to normal."
The Fed does not intend to act as the effective backstop for the corporate debt market forever, nor is it likely to relish the job of propping up zombie companies indefinitely. Yet the central bank has proven reticent to even discuss how it intends to extricate itself from the corporate bond market.
Kicking the can down the road
The Fed's moves to prop up zombie companies may have lasting negative consequences for business performance on a macro scale post-crisis, as the Financial Times explained on Dec. 13:
"The developed world's corporate debt burden has climbed from an already record 91 per cent of gross domestic product in 2019 to 102 per cent at the end of September 2020, according to the Institute of International Finance. Although rock-bottom interest rates make this more bearable, economists fret that this debt 'overhang' will be a millstone around the neck of the global economy for years to come."
Deliberate yield compression has allowed a host of companies to limp along with ever-greater leverage. As a result, many companies will be forced to forego internal investment and growth in favor of servicing debt, as James Mackintosh of the Wall Street Journal pointed out on Dec. 6:
"Some biotechnology and videoconferencing stocks have had their growth accelerated by the pandemic, but shareholders of airlines, shopping-mall owners and travel companies will be using a big chunk of future profits to pay for the debt needed to survive 2020."
Thanks to the Fed's interventions, in tandem with government bailout programs, companies like Delta Air Lines Inc. (NYSE:DAL) will emerge from the crisis more financially strained than ever, having delayed potentially painful restructuring decisions.
Even if interest rates remain effectively at zero for years, as the Fed's public statements on Dec. 16 suggested, sustained bond market intervention is unlikely. The central bank may drag its feet when it comes to normalizing its relationship with credit markets, for a while anyway, but it will happen eventually.
In my assessment, investors who have increased their exposure to either speculative-grade debt in their search for yield, or zombie companies' equity, might do well to reconsider their allocations.
Disclosure: No positions.
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