Zombies and fallen angels: time to revisit high-yield bonds

Zombie companies are generally defined as companies that are more than 10 years old and have an interest coverage ratio of less than one over three consecutive years. Or, put simply, companies that haven’t produced enough profit to service their debts.

Low interest rates following the 2008 financial crisis and Covid-19 support measures led to a rise in the number of so-called zombie companies – those which survive mainly because borrowing is cheap.

However, as we move into a period where interest rates have risen rapidly to levels not seen for 18 years, some of these companies may struggle to stay afloat and could potentially become bankrupt or forced to sell assets to stronger peers. 

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As we 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 very important to be forward-looking when identifying these vulnerable companies and assess their expected future profitability, as well as poor past performance. High-growth companies in sectors such as technology and biotech, are often highly indebted but are yet to reach their full earnings potential. 

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Another category worth highlighting is “fallen angels” – investment-grade companies 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.

As not all fallen angels are necessarily zombies, 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 expected to have peaked, usually shorter duration high-yield bonds could offer an attractive income as well as diversifying your government and investment-grade bond exposure.

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iShares Fallen Angels High Yield Corporate Bond ETF$Dist GBP (LSE:RISE) This exchange-traded fund (ETF) seeks to track the performance of an index 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, Royal London Global Bond Opportunities stand outs. It employs a very flexible unconstrained approach, so can invest across a broad spectrum of global fixed income - investment grade, sub-investment grade and unrated bonds – which means that risks are also diversified, while providing 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.