Start the conversation
Thousands of American companies – many of them publicly traded – are sliding toward bankruptcy.
The U.S. Federal Reserve is buying the bonds of some failing companies in an effort to keep them alive.
But this is one gambit that's not going to work.
The coming tidal wave of bankruptcies will overwhelm the Fed's rescue efforts and could sink the stock market.
Let's face it: Hundreds of companies that were in trouble before the pandemic sealed their fate. Most of them, known as "zombie companies," stayed alive by issuing and rolling over their junk-rated debt.
Yield-hungry investors queued up to buy the high-yielding debt of these wheezing enterprises (mostly in "packaged" form) – understanding there could defaults, but reasoning that a diversified portfolio with a high-enough yield would still net good returns.
Now, in the wake of the COVID-19 pandemic, investors are afraid more companies will default, meaning the risk of holding junk bonds has become untenable for a lot of portfolio managers.
At the same time, companies with investment-grade ratings are facing downgrades as their prospects sink in lockstep with the economy.
An astounding two-thirds of all non-financial corporate bonds in the United States are rated junk or "BBB," which is just one level above junk.
Adding insult to injury: Goldman Sachs Group Corp. (NYSE: GS) in April predicted that more than $550 billion worth of investment-grade bonds will fall to "junk" status by October.
If that happens, the aggregate value of junk bonds would reach a stunning $1.375 trillion.
The fallout will be clear.
Edward Altman, an emeritus professor of finance for the New York University Stern School of Business, estimates about 8% of all firms whose debt is rated speculative grade will default in the next 12 months.
Over the next two years, 20% will go belly-up. Altman also expects at least 165 large firms with more than $100 million in liabilities will go bankrupt by the end of 2020.
Altman isn't alone in sounding the alarm.
Back on May 12, James Bullard, president of the Federal Reserve Bank of St. Louis, announced that "YOU WILL get business failures on a grand scale."
There were 32 worldwide junk-bond defaults in April – 21 of them in America. That's the most in any one-month period since the financial crisis a decade ago.
At the peak of the financial crisis, the global default rate for junk bonds was 10%.
The credit-rating agency Moody's predicts that if the current crisis is more severe than the financial crisis, the default rate could rise to 21%.
It's Not Just a Wave – It's a Tsunami
The coming bankruptcy wave could be worse than during the financial crisis because it will be more widespread, says Debra Dandeneau, a bankruptcy specialist at Baker McKenzie law firm.
All the companies at risk have added debt to their balance sheets within the past three years, and some have rolled over maturing debt regularly – often at higher rates.
As investment-grade debt gets downgraded and sub-investment grade debt prices fall, as investors back away from owning debt products whose underlying issues slide closer to default, the negative effects show up in several ways.
Not only does the equity of faltering companies get priced lower, but hedge funds and other aggressive investors and traders buy credit-default insurance on teetering companies.
Downward pressure on share prices and debt prices alerts other traders to the plight of these distressed companies. And they make additional bets against those struggling companies, sometimes sealing their fate.
The Federal Reserve last month announced its intention to support the secondary market for junk bonds through the central bank's new "Secondary Market Corporate Credit Facility." The program's goal is to buy bonds, including credit ETFs – something the Fed has never done before – to shore up prices of investment-grade bonds, as well as "fallen angels," or junk bonds.
With this move, the central bankers' message to the high-yield market is that they're there and willing to support prices so issuers can continue rolling over their debt and staving off insolvency and bankruptcy.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.