The outbreak of the coronavirus pandemic precipitated an economic crisis unlike anything in living memory. In response, the Federal Reserve has broken with many of its established monetary policy precedents in order to make the economic crisis appear to disappear quickly.
While the central bank's aggressive response has helped stave off a bond market catastrophe for a time, one of the consequences is that it has also led many investors to increase their exposure to the most dangerous debt securities. That may soon become a problem.
The Fed's fight
The Fed's long-standing commitment to maintaining extremely low interest rates bears a great deal of responsibility for the present state of the corporate bond market. Rates have been kept far below historic norms for a decade, which has resulted in suppressed borrowing costs for corporate issuers.
When the economic impact of the Covid-19 pandemic threatened to send markets into a tailspin, the Fed was quick to act, pumping liquidity into the repo market and slashing interest rates to zero. When the high-yield bond market threatened to collapse in April in spite of these largely conventional monetary policy actions, the Fed went still further, financing special purpose vehicles that would allow the Treasury to buy bond exchange-traded funds via a deal with Black Rock Inc. (BLK, Financial), effectively making the central bank the buyer of last resort in all corporate bond markets, including the high-yield market.
As Bloomberg's Brian Chappatta explained in April, the Fed's dive into high-yield bonds had an immediate and profound impact on investor behavior:
"It's hard to interpret the high-yield ETF inclusion as anything other than taking a flamethrower to the somewhat frozen high-yield market and propping up prices. Junk-bond spreads tightened the most since 1998 in percentage terms on Thursday [April 9], while HYG itself surged 6.6%, the biggest rally since 2008."
The Fed's efforts to prop up the corporate bond market have continued apace, which has spurred ever greater investor demand for exposure to the asset class. Indeed, historic demand in December has driven U.S. corporate bond yields to zero on an inflation-adjusted basis.
A cure worse than the disease
As I discussed in a previous article for GuruFocus, the number of companies unable to service their existing debt obligations has hit record levels during the pandemic recession. Many of these so-called "zombie companies" were already struggling before Covid-19 hit, while others have seen their fortunes turn for the worse only recently. Some have been hit so hard that even their Ebitda has turned negative, making them not mere zombie companies, but "negative Ebitda vampires."
Conventionally, companies with insufficient operating income to service their outstanding debts tend to be shunned by capital markets. But, as Zero Hedge pointed out on Dec. 3, these are not conventional times:
"In a normal world corporations with negative EBITDA, with the exception of startups and rapidly growing firms, are on the road to bankruptcy, because they aren't earning enough to make even partial debt payments. But in this downturn, most troubled companies have been able to raise billions in debt and some have even raised equity. As with the 'zombies', there is one simple reason for this stunning propagation of cash burning vampires: the Fed."
Thanks to the Fed, zombie companies, rather than being shunned as in past economic downturns, have received a warm reception from many investors in today's market.
An uncertain prognosis
More capital than ever, including billions of dollars from supposedly conservative pension funds, has been exposed to virulent zombie company debt. In my assessment, that could become a serious problem post-crisis as central bank interventions are scaled back leaving debt-laden zombies vulnerable to a sudden return of more conventional market forces.
Yield compression has forced many market participants, including such traditionally conservative allocators as state pension funds, to dive ever deeper into high-yield credit in recent years. The Fed's interventions have undoubtedly amplified the siren song of the high-yield debt market. Yield hunters should be on their guard lest the seductive tune lure them into even more perilous waters.
Disclosure: No positions.
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