In the US the zombies are awakening as the consequences of the Federal Reserve board’s unprecedented interventions in credit markets continue to emerge.
In perhaps the most peculiar of the developments flowing from the US central bank’s novel policies was last week’s approval by a Delaware judge of a plan by Hertz to raise up to $US1 billion ($1.4 billion) of new equity by selling shares to the public – while it is in bankruptcy!
Shares in the fallen car rental company have, bizarrely, traded at prices as high as $US5.53 since the company filed for bankruptcy with $US19 billion of debt, although they closed at $US1.88 on Monday. The New York Stock Exchange is planning to de-list the shares, underscoring the extent of the risk investors are taking.
The Fed has been buying securities in exchange-traded bond funds to keep corporate interest rates low. On Monday it announced the start of a new program under which it will buy, initially, up to $US250 billion of corporate bonds directly.
Under the program the Fed can buy any bonds issued by a company that held an investment grade credit rating – even one only a “notch” above junk status – on March 22, when the program was announced. Effectively that means the Fed can buy bonds in the so-called “fallen angels,” or companies whose bonds have been relegated to junk status after that date.
Just the announcement of the program worked to thaw a market for high-yield bonds that had been frozen by the onset of the coronavirus pandemic. The stress in credit markets has disappeared and spreads and yields have shrunk.
Access to credit has been plentiful, with the Fed’s own data showing US non-financial debt increasing by more in the first quarter of this year than at any time in the past half-century. US companies borrowed more than $US750 billion in the March quarter.
With cash pouring into the junk bond market and the Fed acting as a form of underwriter for even risky corporate debt, perhaps it isn’t surprising that investors are taking risks that they might not have contemplated previously.
It was instructive that on Monday, before the Fed’s announcement of the start of direct corporate bond purchases, the US sharemarket was down as much as 2.5 per cent. It closed up nearly 1 per cent.
Bond yields actually firmed slightly after sliding on fears of a second wave of the coronavirus, with the Fed’s actions seen as positive for the economy and markets. There is, therefore, a direct cause and effect relationship between the Fed’s actions and announcements and the share and bond markets.
That helps explain why investors, mainly retail, are buying shares in bankrupt companies such as Hertz or highly-leveraged and distressed retailers like J.C.Penney in the belief that the Fed’s interventions will produce a rising tide that will lift all boats, even the sunken ones.
The phenomenon of investors disregarding risk in the belief that they’ve passed it onto the Fed isn’t new. It’s been present in markets since the Fed first embarked on unconventional monetary policies during the financial crisis. The Hertz case is, however, an extreme example of how the Fed’s interventions distort markets by removing risk from any price signal.
The surge in borrowing in the US is another, albeit deliberate, consequence of the Fed’s actions, one that will complicate any pathway to more normal settings in a post-pandemic environment and weigh on the US economy in future.
The US corporate sector was already highly-leveraged even before the coronavirus outbreak. At the start of this year US non-financial corporate debt was already nudging $US10 trillion, or about 47 per cent of US GDP. A decade ago, after a major post-crisis de-leveraging, it was closer to 40 per cent.
About a third of the corporate bond market is now in the form of leveraged or non-investment grade bonds.
More concerning, since the financial crisis - even as the debt levels have climbed - there has been a steady deterioration in the quality of the credit. About a third of the corporate bond market is now in the form of leveraged or non-investment grade bonds.
The levels of leverage and the weak quality of the credit may explain why the Fed has been prepared to take actions it hadn’t previously contemplated, even if it expands and perpetuates a class of companies best described as zombies, kept alive only because the interest rates on their debt are so low and credit is so freely available.
The pandemic might otherwise have decimated the ranks of the zombies, or companies whose earnings wouldn’t cover their interest bills in a more normal environment. With the proportion of zombies among the listed US companies now approaching 20 per cent, that could have created economic carnage.
A problem for the future, and one that has been present since the financial crisis, is how the Fed and its central bank peers elsewhere can extricate themselves from the unconventional settings they’ve created and the unintended consequences and side-effects of those settings, the most potentially threatening of which are the excessive leverage and risk-taking they have encouraged.
On the evidence of the past decade, there is no exit path without implosions in markets, another financial crisis and, at best, another very deep recession. In these circumstances investors are clearly signalling that they expect more of the same.