I point to a rise in zombie companies, dating back to the 1980s and that this trend has the potential to have a negative impact on broader economic growth due to the inefficiency of zombies relative to their peers and as exemplified by the Japanese economy in the 1990s. In a market environment in which risk-free interest rates and risk spreads have declined, investors in debt markets have ‘reached for yield,’ accepting lower quality loans in hopes to increase the yield to maturity on the corporate paper they hold. That degradation in loan quality shows up both in the composition of ratings of speculative grade loans and in the weakening of covenant language in debt agreements – the rules in debt contracts generally designed to protect creditors. By the time the pandemic started, about 80% of leveraged loans were ‘covenant lite,’ meaning lenders had little ability to intervene when the financial health of borrowers degraded, extending the time when zombie firms can persist. Further, adjustments to profitability metrics have become more permissive, enabling borrowers to sustain higher levels of debt tied to those metrics. Perhaps spurred by the popularity of collateralized loan obligations (CLOs), which structurally create incentives for debt investors to keep debt balances high, and a rise in covenant lite debt contracts, out-of-court debt restructurings – in the form of debt exchanges – have overtaken bankruptcies as the preferred venue for dealing with distress. 30% of public firms that underwent a distressed debt exchange between 2017 and mid-2019 filed for bankruptcy by the end of 2019, evidence that these debt exchanges may delay the inevitable for distressed firms and prolong zombie-ism. Payment in Kind (PIK) repayment mechanism that allow borrowers to take on additional debt instead of paying their interest expenses in cash have become the norm, especially in loans used for leveraged buyouts. The optionality that PIK creates to accrue additional debt increases the likelihood that leverage will increase, especially during times of distress for firms that don’t produce enough cash.

All of these factors are worrying from the perspective of market participants and a broad set of stakeholders in the economy. Given the dangers of rampant corporate zombification to investment returns and growth of the economy, the tinder being laid down will need to be addressed through controlled fires to avoid dubious market and societal outcomes.