Masked Zombies (Q1-21)
Jul 06th, 2021
Favorable funding conditions and a strengthening economy have allowed riskier borrowers to avert serious default by extending near term maturities and lowering borrowing costs. In the first quarter of 2021, issuers rated B- in the S&P/LSTA Leveraged Loan Index were able raise US$54.6 Billion to refinance existing debt – a record high exceeding the full year total of US$32.9 Billion in 2019. Sectors such as retail and energy (specifically, oil and gas), which have dominated the corporate default landscape over the past few years, now have fewer distressed borrowers than at the end of 2019. Overall, the default rate of U.S. leveraged loans by amount fell to 3.15% in March 2021, down 102 basis points off the cycle peak of 4.17% in September 2020. This backdrop suggests a benign outlook for defaults but given the unevenness in the global recovery, higher corporate debt burdens and changes in consumer behaviors, we expect more volatility and a growing number of stressed credits.
The Canadian business sector’s balance sheet has remained steady albeit worrisome on a debt-to-GDP basis throughout the pandemic. The debt-to-asset ratio for the entire nonfinancial corporate sector has increased1, while liquidity (measured using the cash-to-debt ratio) has notably improved. Looking at individual components of the balance sheet, debt increased nearly 10% in 2020 but was buffered by rising cash on an aggregate basis. Cash holdings have seen a marked rise: about 28 percent (or $150 billion) above pre-pandemic levels as of the fourth quarter of 2020. Although total cash holdings have increased, the impact of the pandemic has been uneven and cash accumulation has varied significantly at the firm level. The variation in cash holdings across publicly traded firms, for example, indicates roughly one-half of listed companies have drawn down their cash balances while the other half have been growing their cash balances. Most of the total increase in cash holdings is in 10 percent of firms, including those in utilities, telecommunications, mining (particularly gold) and essential retail (e.g., grocery, convenience stores). Not surprisingly, the largest declines in cash holdings were mainly among firms in the oil industry.
Due to loan forbearance offered by banks as well as extraordinary government support measures, the number of businesses in severe financial difficulty has been lower than expected. Small company bankruptcies and proposals in Canada were down 23% on a yearover-year basis for the twelve months ending March 31, 2021, reflecting the fact that the bulk of government stimulus programs for businesses have been geared toward smaller firms. Major banks’ provisions for credit losses on currently performing business loans are an indicator of the banks’ assessment of potential loan losses in the future. As we previously reported, these provisions spiked in the second and third quarters of 2020 but are beginning to normalize. Gross impaired loans as a percentage of total loans made to businesses, however, remain above pre-pandemic levels for most of the big six Canadian banks (Royal Bank of Canada is the only outlier). Given the somewhat subjective nature of accounting for expected credit losses on performing loans under IFRS 9, provisions will be volatile in the first half of 2021 given the economic disruption caused by the ongoing COVID-19 pandemic.
Large borrower insolvencies are on the rise. For the twelve-month period ending March 31, 2021, 61 companies filed for protection under the CCAA, a more than 40% increase from the previous year. More alarming was the 44% jump in liabilities of filing debtors to $10.9 Billion, and a significant shortfall in asset coverage with less than a dollar of book value of assets for each dollar of debt outstanding. This compares to asset coverage a year ago of nearly two to one. Retail was the hardest hit with ten new large companies in the sector entering formal restructuring proceedings over the past twelve months.
A potential risk in the near term is an unexpectedly large and sudden increase in corporate insolvencies once government support programs expire. The astounding financial support provided to some firms over the past year makes it difficult to get an accurate read of the financial health of businesses. In particular, it is not clear whether firms that currently benefit from financial support are financially viable without these programs. Another risk relates to the potential rise in the number of zombie companies. For instance, the decline in the number of business insolvency filings despite the large economic downturn may indicate a potential further “zombification” of companies in Canada. The Bank of Canada estimates that close to 30% of all companies in Canada are persistently unable to generate enough income to make their interest payments.2 That is the highest level on record.
The pandemic is not over yet. The business sector will continue to face challenges as authorities further adjust public health guidelines based on the trajectory of the virus. Some firms that managed to stay afloat thus far may see their financial health deteriorate as the pandemic persists. With timely data on the financial health of private companies lacking (this is especially true for smaller firms), the number of companies infected with the “zombie virus”3 is likely much greater than reported in official statistics.
 Statistics Canada (last observation Q4-2020)
 Bank of Canada, Staff Analytical Note, “COVID-19’s impact on the financial health of Canadian businesses: an initial assessment”
 See our Q3-2018 Investor Report where we describe this affliction.