European ‘zombie’ companies have three to six months' runway before defaults rise, says Aviva Investors

Zombies

Concern is growing over a likely spike in defaults among so-called ‘zombie’ companies that have stayed afloat during the coronavirus pandemic by relying on government stimulus and increasing their debt loads, but will struggle to keep servicing loans as government schemes roll back.

‘Zombie companies’ are indebted businesses that only generate enough cash to cover operational costs and interest payments on their loans, but not the debt itself. 

In the UK, financial services industry body The City UK estimates that businesses may build up GBP100 billion of debt by next March which they would be unable to repay, with 780,000 SMEs in danger of insolvency.

A global forecast by fund manager Janus Henderson for overall corporate debt predicts a jump to a record USD9.3 trillion in 2020.

Jub Hurren, senior portfolio manager of AIMS Fixed Income at Aviva Investors, says that many companies won’t fail immediately, thanks to supportive monetary policy: “The fact that interest rates are going to stay at extremely low levels means that even companies with low earnings can probably survive longer than they would otherwise because of the reduced burden in terms of servicing debt.”

These low rates have also allowed company debt piles to grow. “What we have seen in Europe is an increasing portion of corporates who have interest coverage ratios (the relationship between the EBIT and the interest expense) below one. That's at about 10 per cent in the Euro STOXX index at the moment, which is roughly where it was in 2016. So, we have been at these levels before, but the increase in Q1 was a lot sharper than we've seen before,” says Hurren.

Interest coverage ratios show how easily a company can pay its interest expenses on outstanding debt. Once a company’s ratio hits 1.5 or lower, its ability to pay interest comes into question.

Defaults are already spiking, with Fitch Ratings registering more company defaults in the first five months of 2020 than in the full year of 2019. European companies have been hit with fewer defaults so far than those in the US, thanks to aggressive government stimulus, low interest rates, and a lower weighting on its indices towards sectors like energy, travel, and leisure, which were hit hard by Covid-19.

Hurren has been rotating his portfolio into European high-yield bonds since March and April, but expects the dispersion of returns between sectors and issuers to remain high in the near term.

“An interesting idiosyncrasy of this crisis is that you haven't had that same shock to incomes due to people still being subsidised by the government, which has then meant that people have generally been able to service their debts,” explains Hurren. 

Government policy during the coronavirus pandemic “decoupled the growth cycle and the unemployment cycle”, allowing unemployment to stay low despite huge hits to countries’ GDP. 
Hurren adds: “The main risk for that in Europe is dependent on the part of the government response, and the extent to which we start to see a more sustained rise in unemployment in the Eurozone.” 

If governments start to aggressively roll back furlough schemes and mortgage repayment holiday schemes, defaults in Europe are likely to increase, but Hurren says this is unlikely to happen in the next three to six months: “It seems like we have some more runway before that becomes a problem.”

Nevertheless, S&P forecast in June a baseline 8.5 per cent default rate in Europe by next March, which would see at least 62 speculative-grade companies default.

“Expansive monetary and fiscal support could lessen defaults over the near term, but much assistance to date adds to existing debt piles at a time when basic revenue is lacking,” S&P wrote in a report.

Lenders are feeling the pinch. This week HSBC warned that its bad debt charges could reach USD13 billion this year, higher than previously thought, as a result of its retail and corporate customers struggling to stay afloat.

Douglas Grant, director of Conister Finance & Leasing Limited, says that big banks won’t be able to support these businesses alone: “It is imperative that SMEs have a tripartite level of sustainable support from government, alternative and traditional lenders working together to identify and protect the more resilient sectors such as infrastructure, technology and renewables, ensuring their existence is guaranteed.”