How to protect your investments against the zombie apocalypse

By Kim Iskyan

Zombies - the flesh-eating (sometimes brain-eating) "living dead" that are a staple of horror television and films - are scary. But (fortunately) they're not real.

Zombie companies, though, are real. Like Hollywood zombies, they're multiplying. And they may do more damage - to markets and your portfolio - than brain-eating zombies ever could.

Meet the zombies

Let's say company ABC makes widgets. It borrows money to expand its widget factory - because borrowing money is easy and cheap. So ABC makes more widgets.

But the company's margins are very thin. It makes just enough money to cover the interest payments on its debt. But it can't even touch the principal of the loan.

Most of the time, this spells death for a company. If you struggle to cover your interest payments it's a matter of time before you go bankrupt.

But in recent years, companies like ABC have clung to life for years - for two reasons.

First, low interest rates. Thanks to quantitative easing and nearly a decade of ultra-low interest rates, interest payments are low. So these sorts of companies can borrow a lot of money, pay next to nothing for it and just get by.

Secondly, companies like ABC have benefitted because low interest rates make it difficult for banks to make a profit. What that means is that some banks are more willing to give zombie companies loans than they would normally be.

Also, banks roll over these loans (that is, extend them on similar terms) - even though these are risky loans. Some banks have the attitude that it's better to make a slim profit than none at all - and that they'll worry later about what rising interest rates will mean.

This is not the way things should normally work. But it's how many businesses have managed to survive over the past decade. They've avoided bankruptcy thanks to the miracle of cheap capital.

Zombies, meet death

But interest rates are finally rising - in the U.S. and with time, elsewhere in the world.

The graph above shows the yield of the benchmark U.S. government bond, the 10-year Treasury. The yield on U.S. Treasuries has been rising ever since the U.S. central bank, the Federal Reserve, started raising interest rates in December 2016.

Since the lows of 2016, the 10-year Treasury yield has risen from 1.32 percent to 3.13 percent today.

This means that many of those cheap loans to zombie firms (loans that permissive banks kept rolling over) are getting more and more expensive.

And remember, there was almost no margin of safety for ABC, our thin-margin widget maker. The company was struggling to make its interest payments in the first place. At a higher interest rate, it doesn't stand a chance.

For example… let's say ABC has a net margin of 3 percent (that is, it makes US$3 in net income for every US$100 worth of widgets it sells). It pays US$2 in interest to the bank. That's not a recipe for great wealth, and it's a (barely) viable business.

Until, that is, interest rates go up. Now, after interest rates have (say) doubled, ABC must pay US$4 in interest. It's not that it has more debt - but the cost of servicing that debt has gone up.

All of a sudden, ABC isn't earning enough money to meet its monthly interest payments. (And it hasn't been able to even start to pay down the loan itself - it's only been able to make payments on the interest of the loan.)

Before long, ABC will go out of business. But it won't just go bust (which in a normal economic environment would have happened a long time ago). It will also leave behind a lot of unpaid debt. And the bank carrying that debt will be forced to wipe the loan - marked as an asset on its balance sheet - from its books.

When this happens on a broad scale, it's a risk to global financial stability.

There are lots and lots of zombies

According to the Bank of International Settlements, 12 percent of global companies are now zombies. And 16 percent of U.S. companies are zombies.

That's compared to just 2 percent of global firms being zombies in the late 1980s.

According to the World Bank, that's around 43,000 listed companies worldwide. And there are tens upon tens of thousands more in the private sector.

With rising interest rates, the number of zombie companies at risk is rising sharply.

The former head of the Federal Reserve, Janet Yellen, has warned that US$1.6 trillion in risky, low-quality corporate debt could potentially be downgraded if interest rates continue to rise.

What can you do?

A financial zombie apocalypse triggered by a torrent of corporate bankruptcies - brought about by rising interest rates - could be the trigger for a broad loss of confidence in the markets. It's the sort of thing that could start small… and have big consequences for a lot of asset classes around the world. Zombie companies could do to the global economic system what homeowners with monster mortgages in suburban America did in 2008 and 2009.

This isn't to say that a financial apocalypse is coming soon. By raising interest rates, the Federal Reserve has also given itself more room to re-start its quantitative easing programme should risks to the economy grow. In Japan and throughout much of the European Union, interest rates are still very low.

But as with most crises, the next one could very well happen without any obvious warning. So it pays to prepare for any eventuality.

That means watching your stop loss levels. Remember that cash is the best hedge for any portfolio, all the time. Also, keep some gold, because when everything else falls, gold rises. And remember to macro-versify.

 

Kim Iskyan
Kim Iskyan is the publisher of Stansberry Churchouse Research, an independent investment research company based in Singapore and Hong Kong that delivers investment insight on Asia and around the world. Kim has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets. He's been quoted in the Economist, The New York Times, the Wall Street Journal, Barron's, and Bloomberg, and has appeared on Fox Business News, China Central Television, and Bloomberg TV, and has written commentary for the Wall Street Journal, Slate.com, Salon, TheStreet.com, breakingviews.com, and other publications. For more of his insights, Click here to sign up to receive the Asia Wealth Investment Daily in your inbox every day, for free.

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