Why 'Zombie' Companies are on the Rise—and Could Soon Pose a Threat to the U.S. Economy

In the famous teen comedy “Weekend At Bernie’s”, when their boss dies, a couple of staffers deal with his cadaver the only way they know how: Putting dark sunglasses on him, dragging him around to various parties, and generally making him seem as alive as possible.

A solid comedy premise—and one with more similarities to our current economy than you might think.

In the financial world, companies on life support are called “Zombies”: Those firms which are not even able to cover their debt-servicing costs with current earnings. They are in bad shape, and probably should have gone out of business already.

Yet, they are being kept alive. And yes, they walk among us.

“If a firm cannot meet its debt obligations without taking out even more debt or liquidating assets, it’s a zombie,” says Trevor Noren, managing director of advisory firm 13D Global Strategy & Research, who has long studied the phenomenon. “The longer interest rates stay low, the more the zombie population will multiply.”

In fact across 14 advanced economies, zombies now number 12% of all publicly-listed companies, according to a research paper by the Swiss-based Bank for International Settlements. Within the S&P 1500, 14% of companies could be classified as zombies, according to analysis by Bianco Research. “In the 1980s, the share was a mere 2%,” notes Claudio Borio, head of BIS’ Monetary and Economic Department.

So how have low interest rates helped create all these zombies? Well, think of it from a bank’s perspective: If you have lent millions of dollars to a troubled client, do you want to admit your mistake, watch that company go bust, and have to write off those loans? Or might you grant them even more cheap credit, in order to keep them going a little while longer?

Voila: A culture of corporate zombies.

In a booming economy with rock-bottom rates, it’s pretty understandable. Company fortunes do turn around sometimes, after all, and nobody likes to see any firm—with all those shareholders, and jobs, and pensions—go under.

But in an era of rising rates, or a recession that pummels everybody across the board, there can be rude awakenings for companies that previously “looked” okay.

It’s not just the U.S. dealing with this problem, either. Since low rates are a global phenomenon, there are plenty of the Walking Dead lurching around in Europe and China, as well.

One result of a global zombie economy is that productivity suffers. After all, propping up an army of half-dead companies is not really how capitalism is supposed to work.

“That may weigh on productivity growth in the long run, as the number of zombie firms rises and absorbs resources that could be employed more productively elsewhere—including by competitors,” says Borio.

Active investors should be able to sidestep prominent zombies, says Noren. The state of bloodied companies like Sears, Toys “R” Us and Barneys New York, to name just a few troubled firms, was fairly obvious as they grunted and staggered around.

But what about passive investors? If 14% of the S&P 1500 is now zombified, and you own an index fund, what exactly is your exposure going to be?

After all, individual investors are notoriously terrible at staying calm and collected during market crises. That’s behavioral finance 101. “If a wave of zombie defaults comes, will investors simply sell the entire basket?” asks Noren. “This is a systemic weakness that could rapidly deepen a market downturn, in the even of heightened and sustained economic turbulence.”

For the moment, though, interest rates are falling: The Federal Reserve recently cut rates by a quarter-point, the first such dip in a decade. That will keep corporate zombies on life support, and maybe even create a few new ones.

But if a full-blown recession hits, balance-sheet fundamentals will become critically important, and only the strongest specimens will survive. That’s when you will realize precisely how many zombies have set up shop in your portfolio.

“It’s just a question of whether it will happen gradually over time, or whether a catalyst—like a recession—will force a rapid reckoning,” says Noren. “Either way, it’s coming.”