You can never be sure how you might fare in a zombie apocalypse – let alone one accompanied by a crowd of fallen angels.
Low interest rates following the 2008-09 global financial crisis and the pandemic crisis dawned an entire army of so-called zombie firms – i.e., businesses that barely generate enough revenue to cover their interest payments and are sustained primarily by easy access to dirt-cheap borrowing. They’re more about survival than growth, and have no room for innovation. They exist only as long as they can refinance their debt. Once those costs rise, they start to wither.
Most zombie companies are over a decade old with an interest coverage ratio of less than 1 over three consecutive years. Or, put more simply, they are the businesses that haven’t produced enough profit to service their debts.
But now, with interest rates having risen to levels not seen in a couple of decades, some of these companies may soon struggle to stay afloat and could potentially become bankrupt or forced to sell assets to stronger peers.
As you know, higher interest rates reduce demand in the economy, which can translate into smaller revenues available to cover interest payments. As a result, S&P reported earlier this year that companies around the world are defaulting on their debt at the fastest pace since the global financial crisis, as high rates and sticky inflation continue to take their toll.
It’s important to be forward-looking when identifying these vulnerable companies and to assess their expected future profitability and their poor past performance. Often, high-growth companies in sectors like technology and biotech are highly indebted but have yet to reach their earnings potential.
Then there are the fallen angels – investment-grade companies that have been suddenly downgraded to junk status. A zombie company’s debt can be downgraded to high yield and become a fallen angel. As both fallen angels and zombies are usually highly indebted, their numbers are expected to increase when interest rates are high and accompanied by a slowdown in the economy.
But, not all fallen angels are necessarily zombies and there is an opportunity to invest in these downgraded bonds, taking advantage of an anomaly that exists when they become oversold because of regulations that restrict a fund manager’s ownership of junk bonds. With interest rates likely to have peaked, shorter-duration high-yield bonds could now offer an attractive income and diversify your government and investment-grade bond exposure. At least, that’s how things usually play out.
The iShares Fallen Angels HY CorpBd ETF$Dist GBP seeks to track the performance of an index that’s composed of high-yield corporate bonds from issuers in developed markets, which have been downgraded to sub-investment grade. The fund offers diversified exposure to a subset of high-yield corporate bonds that have been downgraded from investment grade. The current yield is over 5% and the ongoing charge is 0.5%.
For broader actively managed fixed-income exposure including high-yield bonds, the Royal London Global Bond Opportunities stands out. It uses a flexible unconstrained approach, and can invest across a broad spectrum of global fixed income – that means, investment grade, sub-investment grade, and unrated bonds. And because of that, it offers diversified risks and provides considerable opportunities. Furthermore, the short duration of the fund should limit the impact of any volatility that may continue to impact government bond markets. The current yield is almost 6% and the ongoing charge is 0.52%.
Dzmitry Lipski is responsible for fund selection and portfolio construction at interactive investor.
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