Thousands of American companies are sliding towards bankruptcy. Many of them are publicly traded companies.

The Federal Reserve’s buying some failing companies’ bonds in an effort to keep them alive.

It’s not going to work.

The coming tidal wave of bankruptcies will overwhelm the Fed’s rescue efforts and could sink the stock market.

Here’s what’s coming our way.

Zombie Companies Are Starting to Buckle

There are 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 lined up to buy ailing companies high-yielding debt, mostly in packaged form, understanding that there could defaults, but 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, making the risk of holding junk bonds untenable for a lot of portfolio managers.

At the same time, companies with investment grade ratings are facing downgrades as their prospects sink along with the economy.

An astounding two-thirds of all non-financial corporate bonds in the U.S. are rated junk or BBB, just one level above junk.

To add insult to injury, Goldman Sachs in April predicted that over $550 billion of investment-grade bonds will fall to junk status by October.

That would bring the value of junk bonds up to north of $1.375 trillion.

Those Zombie Companies are Pulling Down the Weak

Edward Altman of NYU Stern Business School estimates about 8% of all firms whose debt is rated speculative grade will default in the next twelve months.

He believes 20% will go belly-up over two years. Altman also expects at least 165 large firms with more than $100 million in liabilities will go bankrupt by the end of 2020.

“You will get business failures on a grand scale,” announced James Bullard, president of the Federal Reserve Bank of St Louis, on May 12th.

There were 32 worldwide junk-bond defaults in April, and 21 of them took place in America. That’s the most in any one-month period since the financial crisis.

At the peak of the financial crisis, the global default rate for junk bonds was 10%.

Moody’s credit-rating agency predicts that if the current crisis is more severe than the financial crisis the default rate could rise to 21%.

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.

The Federal Reserve’s been supporting the secondary market for junk bonds through its Secondary Market Corporate Credit Facility, including buying credit ETFs, something they’ve never done before.

Their 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 stave off bankruptcy.

But it may not be enough. The Fed would have to buy hundreds of billions of dollars worth of junk bonds to save the secondary market from selling off as it faces the coming wave of expected bankruptcies.

If the Fed’s not willing to take over an entire market and saddle itself with potentially billions of dollars of losses, to say nothing of becoming creditors to bankrupt companies, plummeting junk bond prices and rolling bankruptcies could frighten equity market investors into selling stocks.

You’ve been warned.

Until then,

— Shah

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Source: Total Wealth Research