The Invasion of Zombie Companies that Wasn’t

Investors and policy makers have long worried that ultra-low interest rates would give rise to a legion of zombie companies — firms that survive mainly because borrowing is cheap and plentiful. But there are reasons to think the number of zombies is smaller than some feared, according to Goldman Sachs Research.

Zombie companies are typically defined as firms that haven’t produced enough profit to service their debts (also known as an interest coverage ratio below one) for three straight years. Based on that definition, some 13% of companies based in the U.S. could be considered examples of the living dead.

But that metric captures a swath of enterprises, typically technology companies, that are high growth firms, according to Goldman Sachs Research analysts Michael Puempel and Ben Shumway. These companies are often young, and investors expect them to have high earnings in the future. Investors see them as companies that are yet to reach their potential rather than nearing the end of their lifespan.   

Goldman Sachs Research accounted for this by only including firms whose equity underperformed the S&P 500 Index of U.S. equities by at least 5% in each of the past two years. With that filter in place, the number of so-called zombies shrinks to less than 4% of U.S. companies, accounting for around $200 billion of net debt.

Put another way, the enduring myth of the zombie firm is partly a classification error. “There are not nearly as many zombies as some of the headline data might suggest,” Puempel says. “The percentage of real ones is far smaller than reports have indicated.”

That’s not to say there are no zombies in the credit market. The number of financially wobbly companies tends to grow between recessions, and many were wiped out through defaults when the economy abruptly stopped in 2020 at the onset of the COVID pandemic. Goldman Sachs Research focused on companies with public filings in the U.S., and the researchers didn’t have data on private loan markets; there are likely some zombies in that market that they weren’t able to observe.

“While zombies do build up over time, there is also a mechanism to remove them from the system once economic growth decelerates considerably,” Puempel says. “And so with negative shocks and ensuing default cycles, you do see creative destruction within the corporate bond market.”

While interest rates are climbing rapidly now, government bond yields in the U.S. and other developed countries were subdued for years following the financial crisis in 2008. Economic research has documented signs of corporate zombification in Japan in 1990s and, more recently, in the eurozone as the European Central Bank undertook unprecedented measures to ease funding markets starting around 2012. The Federal Reserve, likewise, bought trillions of dollars of U.S. government bonds after financial crisis to stimulate the economy and likely lowered borrowing costs for companies.

But despite the unprecedented policies of this century, there aren’t signs that credit markets in the U.S. have showered zombies with funding “en masse,” according to Goldman Sachs Research. A research report from our analysts in October 2020 indicated that the primary market where companies go to raise funding was essentially shut to zombie borrowers, and the secondary market where these securities trade wasn’t particularly welcoming either.

“The public markets are actually pretty good at efficiently allocating capital away from the zombies,” Puempel says.