The zombie motif was popularized by the horror movie “Night of the Living Dead” where zombies and vampires morphed into aggressive and deadly undead preying on humans. The zombie concept moved into finance with the advent of Zombie Banks in Japan in the “lost decade” of the 1990s. Those Zombie Banks were kept alive by accommodative central banks ,even though a majority of their assets were often non-performing.
Recently, the Zombie Bank discussion has focused on Chinese financial institutions who are insolvent because they have financed “see through” apartment complexes and also participated in shadow banking activities.
In all these cases it is accommodation from a government or central bank as part of monetary policy that keeps these undead institutions going. However, I never would have expected similar support for undead corporations from supposedly Darwinian capital markets around the world.
US Capital Markets Have Many Zombie Companies
The number of undead public companies trading in the US capital markets surprised me. According to The Wall Street Journal “Daily Shot” and an article by Nicolas Rabener from Factor Research more than 10% of publicly traded stocks in 14 advanced economies with market caps in excess of $500 million have higher interest costs than operating earnings . In the US capital markets that number is 8%, matching the Zombie percentages from 2006.
In these studies by the Bank of International Settlements (BIS) a public corporation is a Zombie if its interest coverage ratio (ICR) has been less than one for at least three consecutive years and if it is at least 10 years old. By comparison, healthy public companies have a worldwide ICR of 4x and a US ICR of 9.7x. This chart shows the general rise of indebtedness of non-financial publicly traded companies in the US. Notice the almost 50% increase from 2008.
In fact, these “Zombie public companies” which are functionally insolvent are actually trading at a surprisingly small discount to the S&P 500:
The BIS and Rabener research conclude that a persistent falling interest rate from 1986 to 2016 has actually made these zombie companies look like they are improving because, even though they are not paying down principal, their ratios improve as their interest burden falls. The research also concludes that weak banks do not demand restructurings and bankruptcies in periods of low interest rates. The Zombie banks are keeping the Zombie corporations alive.
By Comparison PE Banks Are Quick To Act
This is a major divergence from the banking world we live in.. In the private equity world if you have a small company with an EBITDA to interest ratio of less than 1:1 you are on your way to a special assets group where the bank’s work out people will direct cash flows to debt retirement by shrinking available leverage. You have to wonder how these Zombie companies in the public realm avoid similar treatment, especially in a period of rising interest rates where their ratios are now deteriorating?
One piece of useful research would be debt prices on public debt issued by Zombie corps. The debt markets always focus on repayment so their trading prices usually assess survival risk in the right way. How many of these Zombies have public debt that trades at a discount to par?
Is There An” ETF Effect” Lifting Zombie Prices?
I also wonder whether it is the ETF effect? With the shrinking number of publicly traded companies and the proliferation of financial products that attempt to mimic an index, is it conceivable that ETF managers mimic the indexes by buying undead companies in their tracking portfolio. If Zombies are 8% of the market above $500 million market cap, does the ETF portfolio intentionally include Zombies to make the ETF a true proxy? Without price discovery on an individual basis, these undead may just be pulled along by a tide of capital inflows?
If this is what is happening, maybe the ETF prospectus should warn: “The manager will buy securities of ZOMBIE publicly traded companies that have the inability to generate operating profits in excess of their annual interest expense”
In any event, keeping Zombies alive might be important enough monetary policy for full employment , retirement funding and bank health that Jerome Powell and the FED have another reason to think about getting to the neutral rate fast and showing accommodation rather than tightening?