Why a global zombie infestation isn't necessarily a bad thing (for markets)

Like any good millennial, I have seen my fair share of zombie movies and television shows. 

Take The Walking Dead for instance, in which the world is brought down by a global zombie apocalypse. Or the much more humorous Shaun of the Dead, featuring the wonderfully witty Simon Pegg. Or the strangely heart-warming romantic film Warm Bodies, in which these brain-dead antagonists are transformed into love interests. 

All this is to say that we humans have an awful infatuation with the un-dead. That is, until it comes to "zombie companies". 

According to KKR's Jeremiah Lane, investors fear the living dead (or CCC-rated businesses) because they believe they could lead to a flood of defaults. As interest rates rise, that fear has become almost palpable. 

But it also pays to have some historical perspective. The long-term average is only a 2.5% default rate each year, and recoveries are typically in the 30 cents on the dollar range. 

"When something gets rated CCC, the buyer base collapses... And just at that moment when the buyer base collapses, a number of investors that held that asset previously, when it was better rated, are suddenly sellers of it. And so what we like about it is it's an area of the market that is consistently cheap," Lane explained. 

That doesn't mean investors should employ a broad brush approach when investing in these businesses. As Lane outlines, a much more targeted strategy is required. 

In this Expert Insights video, Lane shares why select zombie companies can actually provide opportunities for credit investors.

Plus, he also explains why we are likely to see a flood of downgrades (and defaults) on the horizon. And perhaps surprisingly, why these won't be caused by the fresh rising rate cycle. 

Note: This interview was recorded on the 15th of September. You can watch the video or read an edited transcript below.

Edited transcript 

Will rising interest rates lead to the beginnings of a default cycle? 

Jeremiah Lane: 

We don't see a particular likelihood of interest rate hikes causing a major rise in defaults. The biggest reason for that is that businesses that borrow in floating rate, the businesses that have bank loans that are floating rate, more or less hedge floating to fixed. 

So when they put in place their bank loan, many of them go and either swap floating to fixed, or they buy a cap from a bank that limits their risk to a rising rate environment.

Many businesses that borrowed, especially last year, were able to do that at just rock-bottom rates. And so, as a result, many of these companies are not directly exposed basis point for basis point to the Fed hikes. 

And so it's not interest rates that we think are going to cause a major spike in defaults. To our mind, it's going to be weaker revenue. It's going to be the combination of weaker revenue with profit erosion. Maybe they have inflation that they're not able to pass on to their customers. It's going to be more about the fundamentals of the business than about the rate that they're paying their lenders because many of the companies have protected themselves that way. 

Could we see a flood of downgrades on the horizon?

I think it's likely that we're going to see more downgrades and more defaults. I think that we're going into a market environment, a fundamental macro environment, that is weaker, and we've already started to see it in some cases.

We've seen a large pharma business recently file for bankruptcy. We saw a theatre's business file for bankruptcy, called Cineworld (LON: CINE). We saw Avaya (NYSE: AVYA) the phone maker - they haven't filed for bankruptcy yet, but many people are expecting that they will. 

We're seeing those stresses emerge, but the common thread among those stresses is that their businesses have fundamental problems. That's what we think will drive the next wave of defaults, a weaker macro environment. 

Businesses that already have fundamental problems just running out of the ability to live, to fight another day. 

Could this actually be an opportunity? 

So many people look at CCC-rated businesses and they use different terms for them. They call them zombie companies. They think they're incredibly risky, "junk" etc. 

And you know, what we see in CCC-rated loans and bonds is businesses that have gone through some transition. Maybe COVID hit them particularly hard. Maybe they had particularly large exposures to commodity prices. Maybe they had an inability over some time period to pass through price increases. 

When something gets rated CCC, the buyer base collapses. Take a bank loan, it goes from being a good asset for CLOs, they're 70% of the market. A good asset for insurance companies, they're 15-20% of the market. All of a sudden, it's really only a good asset for a small handful of total return seekers. 

So the buyer base really collapses. And just at that moment where the buyer base collapses, a number of investors that held that asset previously, when it was better rated are suddenly sellers of it. And so what we like about it is it's an area of the market that is consistently cheap. 

Now, what I think would be the wrong approach to investing in CCC or zombies would be to buy a broad cross-section. We don't believe in that. If you're investing in these parts of the market, you need to make really targeted investments. You need to pick your spots. We're bringing to bear the diligence capability that we have as part of KKR to build really high conviction in the small number of investments that we're making. 

And then if we're right, we've bought something really cheap that turns out to be actually a good business, not a zombie at all, just mistaken for a zombie because of some short-term fundamental challenges to the business. 

How many companies typically default each year?

So when people talk about zombie companies or they express fear around CCC-rated businesses, a lot of times, what they're really saying is we think there are going to be a lot of defaults.

And when we step back and talk about the high yield market overall, what we've seen over the long term is about a 2.5% default rate per year. Historically, for the market overall, recoveries have been in the 30 cents on the dollar range.

In our strategy, over our 14-year track record, our default track record is 1.4%. So more than 100 basis points better than the market overall. And we have historically been able to get a 70% recovery on our default. So substantially less loss when we get a default.

Of course, we make mistakes, just like everybody makes mistakes. But with our approach of being really targeted on the risks that we take and the risks that we include in this portfolio, we've been able to have lower defaults than the market and better recovery than the market.

Which sectors look worrying right now?

For the areas that we're worried about right now, I would call out a couple of sectors and I would call out maybe a couple of themes that we think are interesting.

Housing-related businesses, building products, real estate brokerage businesses, lenders - those are really tough right now.

The results that we've seen through the second quarter of 2022 have been good. And we see those results and we see the affordability challenges for first-time home buyers in the US, and it just looks to us like activity in that space has to slow a lot. And so we're being really judicious about how we put risk to work in that space. That's historically been a space that we've liked because there were a lot of tailwinds around housing construction in the US after a really sustained period of low construction post-financial crisis. But that's a space that we like less right now.

We are trying to avoid businesses that have a high degree of exposure to specifically low-wage labour. Low-wage labour is one of the areas we are seeing the most acute labour shortages and most significant wage inflation.

Some of those businesses have the ability to pass it on to their customers, some don't. Some have the ability to pass it on, but with a lag. We're trying to be really thoughtful about how we invest in that space and make sure that anything that we're doing that has high exposure to low-wage labour has a strong ability to pass through very quickly so that we don't find ourselves with a sustained period of low earnings.

There are some things that we think are attractive. We've seen some businesses that were disrupted early. Some businesses that import goods from Asia were hit very heavily last year by the cost of shipping, some businesses were not able to fully staff themselves when labour was particularly tight. And so they had lower revenue because they weren't able to staff up accordingly. And some of that pressure is abating now. So there are some sectors that we think are interesting. But again, we don't see that individual sector that feels like we want to go max risk on or max risk off. Right now, the market is a little bit more idiosyncratic. 

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