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Is a Zombie (Company) Apocalypse Upon Us?

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Rising interest rates could unleash a zombie company apocalypse – if the Fed lets it happen.

Corporate bankruptcy levels in the US hit seven-year highs last month.

New Chapter 11 bankruptcies surged 63% year-over-year in March. All-told 770 companies filed for Chapter 11 protection last month. That is the highest level since April 2011.

According to Business Insider, corporate bankruptcies normally spike in April and ebb late in the year. But last December, filings spiked 61% from November to the highest level for any month since April 2013. The December surge in bankruptcies was an ominous sign – and it looks more ominous in light of March data.

This could just be the proverbial tip of the iceberg. As interest rates climb, we’re likely to see the number of corporations going under continue to climb.

The yield on 10-year Treasuries cracked through the 3% level this week. This represents the cost of servicing government debt. As a Palisade Research article pointed out, “The U.S. Treasury will get funded no matter what – foreigners will buy the debt, or the Fed will print dollars to do it. Either way, they will borrow – no matter the cost. But individuals and companies that borrow aren’t as lucky. They’re forced to pay the higher interest payments.”

According to Palisade, there is over $7.5 trillion in debt floating around out there that is highly vulnerable to rising interest rates.

To evaluate business sector debt, we need to look at the LIBOR rate. As Palisade explains it, “LIBOR stands for London Interbank Offered Rate and is a benchmark rate that the world’s leading banks charge each other for short-term lending. It’s the first step when calculating interest rates on various kinds of loans – whether government bonds, corporate bonds, mortgages, or student debt.”

The LIBOR rate tends to move in tandem with the Federal Reserve Funds Rate, historically remaining slightly above it. Using Fed data, JP Morgan calculated that there is about $7.5 trillion in pure LIBOR-related debt. According to Palisade:

Syndicated loans (loans offered by a group of lenders to provide funds to a single borrower) are 97% tied to the LIBOR rate. Both corporate and non-corporate business loans and commercial mortgages are about half tied to LIBOR. To put this in perspective, a 35-basis point increase could raise business loan interest costs by $21 billion. So, with yields rising – both on the short end and the long end of the curve – this could hurt the business sector. Which means the stock market.”

As we reported earlier this month, there are a lot of zombie companies lurching around out there.

Corporate credit downgrades have outpaced credit upgrades since the first quarter of last year and the spread between the two has gotten progressively worse. In the fourth quarter of 2017, the number of credit downgrades was better than 50% higher than credit upgrades.

A zombie company’s operating profits can’t cover even the interest payments on its debts, much less repay the principle. According to the Bank of International Settlements (BIS), the number of zombie companies has risen above pre-crisis levels. As an article in the Financial Times noted, “Zombie borrowers are especially vulnerable to rising interest rates and risk collapse as the quantitative easing taps are turned off.”

And that’s exactly what is happening. The easy money spigot is shutting down.

We’ve already seen a number of high-profile corporate bankruptcies, particularly in the retail sector. Toys R Us was probably the highest profile. It ranks as the second-largest US retail bankruptcy ever, according to S&P Global Market Intelligence. Most people blame Amazon, but the real story behind the Toys R Us bankruptcy gives us a glimpse at a fundamental problem eroding the strength of the economy – easy money created by Federal Reserve monetary policy.

The rate of bankruptcies will likely accelerate over the next several years and spread into other sectors if the Fed follows through on its monetary tightening policies. The ugly truth is that these overleveraged companies simply can’t survive in anything remotely resembling a normal interest rate environment.

But the folks at Palisade don’t think the central bankers will let all of these companies buckle under the weight of rising interest costs and ultimately pop the stock market bubble.

 If things get too bad, the Fed will come in to save the day by lowering rates to keep these ‘zombie’ companies going. They always do.”

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