Rising interest rates and slowing economic growth combined with the unprecedented volume of corporate debt are set to challenge credit ratings, with risks related to “fallen angels” and “zombies” likely to prove particularly acute, Scope Ratings agency noted in a recent report.
Investment-grade companies suddenly falling to junk status – the so-called fallen angels – and companies kept alive by banks, investors and low interest rates – the zombies – are phenomena that typically become much more prevalent in a major downturn.
“We are concerned about challenges to ratings during the next major downturn, based on vulnerabilities from high debt levels and weak margins, hence our concern about fallen angels and zombies,” says John Opie, analyst at Scope. “It’s also why our corporate rating methodology aims to anticipate economic downturns by rating through the cycle in a forward-looking manner and by adjusting published debt to better reflect real-world debt burdens to avoid surprises”.
Debt sustainability is the greatest risk to financial stability, even if there is no single threshold triggering a debt crisis. Scope anticipates rapid increases in challenges for heavily indebted corporations – as well as sovereigns and households – if interest rates rise beyond 200 basis points from current levels.
While Scope does not expect a major downturn in the world economy in 2019 (although it does expect a slowdown), it is prudent to review what the effects of one might be given the increasing vulnerability of borrowers.
Fallen angels are particularly hazardous as the deterioration in credit circumstances that moves an analyst to downgrade one company below investment-grade can quickly accelerate if the downgrade unnerves the broader market, effectively resulting in a self-fulfilling prophecy.
Large numbers of zombie companies, as Japan discovered in the 1990s, increase the risks of debt traps, where policy makers face constraints on needed interest-rate increases because of corporate, public-sector or householder indebtedness. Capital deployed by zombie companies also cannot be redeployed for more productive use. Estimates put zombie firms at 12% of all companies in industrialized countries in 2016, up from less than 6% in 2000, with the likelihood that a zombie remains a zombie – it doesn’t become profitable or isn’t shut down – having increased to more than 85% from almost 75%.