Remember, the U.S. Federal Reserve hasn’t raised interest rates since 2006. And it has kept rates near zero since the end of 2008. In that time, corporate America has grown addicted to cheap debt.
Corporate treasurers refinanced $1 trillion worth of debt each year between 2012 and 2014. Some of that debt has gone to finance acquisitions. Some has gone to finance returns to shareholders in the form of stock buybacks and increased dividends.
But weaker companies – those whose high-yield debt is known as “junk” – have been borrowing just to keep the doors open. And borrowing by these companies was up 21% in the first six months of the year from the same period in 2014.
A Fed interest rate hike will force such “zombie” companies to pay investors more to buy their debt. And many won’t be able to afford it.
Why Junk-Rated Companies Dread a Fed Interest Rate Hike
“Because BB-, B-, and in some cases CCC-rated companies have been able to borrow at less than 5%, a host of zombie and future zombie corporations now roam the real economy,” bond guru Bill Gross wrote in his August letter.
Such companies face an existential threat from a Fed rate hike. And if the Fed doesn’t raise interest rates in December, it will almost certainly raise them in early 2016.
We’re already seeing signs of trouble. So far this year, 47 companies have defaulted, the most since 2009.
And Standard & Poor’s U.S. distress ratio, the portion of distressed securities among junk bond-rated companies, hit 15.7% in September. That’s the highest level since December 2011.
One zombie company, Unisys Corp. (NYSE: UIS), ran into problems in September when it had to withdraw its offer to sell $35 million of bonds. The junk bond offering, with an expected yield of about 8%, failed to price. Investors wouldn’t bite.
The Unisys withdrawal was the 15th of the year. So far in 2015, $4 trillion in bond offerings have been withdrawn.
But investors should know a Fed interest rate hike will hit some sectors harder than others. Here are the ones most at risk from a Fed rate hike…
Who Gets Hurt from a Fed Rate Hike
S&P predicts defaults among junk-rated companies to hit 2.9% by June of next year, double the rate three years earlier. Fitch Ratings thinks the default rate will reach 3.5%.
If the Fed continues to raise interest rates – a good possibility since they’ll be starting from zero – more zombie companies will be put at risk.
A good place to look for companies threatened by a Fed rate hike is Moody’s B3 Negative List. Any company with debt rated B3 or worse – B3 is actually six notches down into junk territory – is considered at a high risk of default.
The list for Q3 grew by 41 to 223 companies, up 8% from the previous quarter, and up 27% from the same period a year ago. It’s the most companies on the list since Q2 of 2010.
The oil and natural gas sector tops Moody’s watch list, with 53 companies, or 23.8% of the total. This is not a surprise, as many oil and gas companies borrowed heavily to finance drilling operations in the nation’s shale formations before oil prices plunged last year.
Beware of These Zombie Companies
Oil and gas companies added to Moody’s list in October include such companies as Exco Resources Inc. (NYSE: XCO), SandRidge Energy Inc. (NYSE: SD), and Basic Energy Services Inc. (NYSE: BAS).
“Many of these oil and gas companies, particularly exploration and production companies, are under liquidity pressure and have seen their ratings downgraded,” said Moody’s analyst Julia Chursin. “With this pressure remaining, we expect the number of energy issuers on the list to keep growing.”
In second place on Moody’s list is the business services sector (13.9%), followed by retail (7.2%) and media (5.8%).
Some notable non-energy stocks on the Moody’s watch list with negative outlooks include Sprint Corp. (NYSE: S), Weight Watchers International Inc. (NYSE: WTW), and Advanced Micro Devices Inc. (Nasdaq: AMD).
While junk-rated companies are most at risk from a Fed rate hike, any company with a lot of debt will be negatively affected. That means investors need to start paying even closer attention than usual to the balance sheets of companies they’re looking to buy.
“Finally investors are starting to wake up,” Michael Contopoulos, a strategist with Bank of America Merrill Lynch, told the Financial Times. “They are starting to trade on earnings and they’re starting to trade on downgrades.”
The Bottom Line: One of the ramifications of a Fed rate hike will be the culling of zombie companies – firms with a lot of junk-rated debt that have stayed alive only because of low interest rates. We’ve already seen a spike in defaults, and it’s projected to get worse next year. Now more than ever, investors need to take a hard look at a company’s debt position before buying the stock.
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