With historically low interest rates before the Corona Crises, corporate debt has skyrocketed. According to the Federal Reserve Bank of St. Louis, Nonfinancial Corporate Business Debt has eclipsed $6.5 TRILLION. Low interest rates have given rise to “zombie corporations.” A “zombie corporation” only generates enough revenue to service its own debt, and as a result, has no real growth. Low interest rates are the only thing that enables a zombie corporation to stay viable.
Simultaneously, investors in search of yield in the face of these historically low interest rates turned to corporate bonds, often under the pretext that corporate bonds provided a safer, less volatile alternative to stocks.
But like any debt instrument, a corporate bond’s value is only as reliable as the borrower’s ability to pay off the debt. And now that the Corona virus has brought the global economy to a standstill, corporate earnings projections for this quarter and next look bleak (to put it mildly). Assuming earnings plummet, the likelihood corporations that have over-borrowed (zombie corporations in particular) default on the corporate bonds they have issued skyrockets. This problem has begun to reveal itself in the corporate debt market. Consider that iShares IBoxx $ Investment Grade Corporate Bond ETF (LQD), one of the largest ETFs tied to investment grade corporate debt, has fallen 18% since March 2, 2020. Similarly, the market for non-investment grade, high yield bonds (also known as “junk” bonds) has also fallen. The iShares iBoxx $ High Yeld Corproate Bond ETF (HYG), one of the largest ETFs tied to junk bonds, has also fallen 18% since February 2020.
That leaves investors who believed they had purchased a reliable, fixed income instruments in the cross-hairs. If zombie and other corporations can no longer generate the revenue necessary to service their debt, they’ll default, leaving their bond investors high and dry.