corporations which can't even cover their interest expense with cash from operations, a list which has grown to 20% of all Russell 3000 corporations profiled last month
... and then there are those companies which, for lack of a better word, one can call vampires: not only do they not have enough cashflow to cover interest expense, but they don't have any cash flow period and burn cash outright as they have negative EBITDA.
These are the companies which Hyman Minsky would define as engaging in Ponzi Finance, which is the state of financialization right before the infamous Minsky Moment pushes the cycle into the Bust phase, and where companies have to rely on new debt merely to fund operations.
Of course, cash burning companies are nothing new and some of the most valuable companies in the US - such as Tesla - have negative EBITDA, but that is because they are growing so fast they are scrambling to capture market share with no regard for profits (aka the Amazon model). These are the companies that can access equity capital markets with ease and get new funding with one phone call.
However, when mature, formerly profitably companies with little to no growth and massive debt loads start burning cash, that's when things get ugly.
Unfortunately for the US economy, negative EBITDA companies are growing at a feverish pace. As Bloomberg reports, a growing number of junk-rated corporations including Delta Air Lines and Royal Caribbean Cruises are losing money even before they pay interest and other necessary expenses like taxes. They’re covering those costs with cash they still have and with more borrowing in the bond and loan markets, where investors are willing to bet that companies will recover relatively fast after Covid-19 vaccines arrive.
Just how fast are these vampires spreading? According to Bloomberg calculations, in the latest quarter, the number of junk-rated corporations with negative EBITDA reached an eye-popping 47, nearly double the level in the second quarter, out of a universe of about 600 borrowers.
Companies such as Delta, Royal Caribbean and United Airlines Holdings are among those that have seen trailing-twelve-month Ebitda turn negative in the third quarter. Many of these are in industries hit hard by Covid-19, including tourism and live entertainment.
The 47 companies in the Bloomberg Barclays U.S. Corporate High Yield Bond index that posted negative adjusted Ebitda for the 12 months ended in September compares with just 26 in the second quarter. And they reflect only a portion of the firms currently burning cash, given that the analysis excludes most companies that aren’t public and corporations in the financial sector. By other, more stringent definitions, such as subtracting expenses including interest and capital expenditure from Ebitda, even more firms are turning in a less-than-zero performance.
As noted above, 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.
As Bloomberg notes, while the Federal Reserve is helping these companies limp along by keeping interest rates near zero and forcing investors that want decent returns to finance insolvent businesses, "money managers won’t be willing to lend to weak corporations forever" and yet it's unclear just what will change: the Fed will not hike rates for years and it continues to inject $120BN in liquidity every month indefinitely.
Yet while most investors are willing to use "other people's money" to keep this bubble going, some are getting worried such as Noel Hebert, director of credit research at Bloomberg Intelligence who said that debt markets may not be paying enough attention to the risk of cash and financing running out. He added that "even if the pandemic ends sometime next year, businesses will have to deal with their growing debt levels and an economy that may look very different after Covid-19." That's ok though: by then the Fed will likely push rates negative allowing bankrupt companies to issue 2%-yielding debt and stay alive.
"We’ve got companies where we don’t know if they’re functionally okay or not because we don’t know what the economy looks like on the other side of Covid," Hebert said. "You’ve got companies that need a fast solution to figure out how to make their debt levels work, and absent that, those are companies that over the course of the next year may need to file for bankruptcy."
The irony is that while the Fed directly feeds this debt bubble, it is at the same time warning about the pernicious consequences of too much debt. NY Fed economists wrote this week that companies that came out of the last big downturn with higher debt loads ended up performing worse than their peers (Fed researchers are not know for uncovering something most people don't already know). What the Fed also "found" is that in this cycle, firms in industries like tourism, travel and hospitality could grow as much as 10% slower than in ordinary times, based on figures seen after the financial crisis and companies’ debt levels coming into this downturn. And yet, instead of pulling the plug and allowing creative destruction to take place, the Fed continues to ease financial conditions, ensuring that these companies will have even more growth-crushing leverage in the near future.
Meanwhile, junk bonds financing these insolvent vampires have gained around 5.5% this year, after returning more than 14% last year, and with the world starved for returns, asset managers have no choice but to fund these cash-burning, ticking timebombs.
"Debt investors are willing to cross their fingers and go, ‘OK you’re not profitable, but we think someday you can be again,’ which is a tricky way to invest," Hebert said.
One company which took advantage of bond market desperation is Carnival, which last month borrowed $2 billion in unsecured corporate debt, paying an interest rate of just 7.625% on USD and euro-denominated notes. Bizarrely, this is far lower than the hefty 11.9% yield it had to pay on debt secured by its ships in April, when investors were less confident in the timing of a return to normality. They also weren't confident that the Fed's purchases of corporate debt would stabilize the market.
"What these companies are going through is temporary, that’s the bottom line,” said Kevin Mathews, global head of high yield at Aviva Investors, unless of course it isn't. "If they’ve raised enough money in the market to survive until their business comes back, then those default rates aren’t going to be as bad as we thought." This, as Minsky would explain to Kevin, is what Ponzy finance is all about.
While none of this should come as a surprise to anyone following the dismal dynamics in the bond market, where the more companies face insolvency if it weren't for the Fed, the lower yields are, there was one curious observation: in Q3 high-yield companies were able to cut their debt burden in the third quarter. Leverage, or the ratio of total debt to EBITDA on average for high-yield companies ticked down slightly to 5.27x in Q3 from the historic high of 5.57x in the three months ended June 30.
Yet a closer look reveals that this metric is misleading: the improvement is only because of quirks in how aggregate leverage is measured, as any company with negative Ebitda was removed from the figures because leverage becomes meaningless when that occurs, making the average look better. In other words, the more companies default, the prettier the aggregatie picture! OH, and also, several companies left the index in the third quarter after filing for bankruptcy.
The reason for the relentless surge in debt is that most companies who still have access to capital markets went on a borrowing spree in recent months while keeping the cash on their books as a back up in case their situation gets worse. While that money can be used to pay down debt in the future, it most likely won't as it will be used to fund ongoing operations first, with little to nothing left over for debt repayment.
It is these massive debt loads that will be a drag on the economy in the years to come and weigh on growth even further, said Michael Collins, senior multi-sector portfolio manager at PGIM Fixed Income. Companies hard-hit by the pandemic have been laying off workers and cutting back on investments to cut costs. "They really focus on survival rather than growth," Collins said.
Ironically while all of these companies would benefit from bankruptcy as it would wipe the debt-slate clean, that is not happening as the Fed's policies keep the equityholders in the game, even though they should have been wiped out long ago.
Of course, there is a silver lining: all of these companies will benefit if the global economy sees a rebound in the second half of 2021 as most analysts expect, but that won’t necessarily extend to businesses that might be facing long-term reductions in revenues as consumer habits change, according to Collins.
"If you thought the last decade coming out of the financial crisis was a poor or weak recovery, which it was by historic standards, I think the recovery this cycle is going to be worse than that because of all the debt overhang." Debt, which was only made possible because of the Fed... but don't expect to read a NY Fed research paper focusing on why the corporate debt crisis is now deeply embedded in the fabric of the economy and will ensure that GDP growth in the coming decade will remain deeply depressed.
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