When central banks around the world began lifting official interest rates last year to tackle soaring inflation, companies with high levels of debt were effectively put on notice…

Now, roughly a year later, we’ve already seen the highest level of corporate debt defaults since late 2020.

Separate reports released in April by credit rating agencies Moody’s and Standard & Poor’s documented a surge in corporate defaults during the first quarter of 2023, fuelled by higher interest rates, energy prices and lower revenues.

Both agencies expect corporate defaults to continue rising over the year as companies experience slower growth, revenue lag, cost pressures and restricted access to capital.

Monthly insolvency data released by the Australian Securities and Investments Commission on 24 April shows 828 companies entered into external administration or had a controller appointed in March this year, a 78.4 per cent increase on the same month in 2022.

Zombie companies on the rise

The rise in corporate defaults is running parallel to a sharp rise in so-called “zombie companies”.

These are companies that are effectively on the brink of default, because they are struggling to generate enough operating cash flow to service their outstanding debts.

A report released in September 2022 titled ‘The walking debt: Zombie companies are on the increase worldwide’, by the consultancy Kearney found the number of listed zombie companies around the world had risen by 10 per cent in 2022 to almost 2,000. This largely reflected multiple rises in interest rates.

Kearney relied on the Organisation for Economic Co-operation and Development (OECD) definition of a zombie company. According to the OECD, they are companies that have been publicly listed for more than 10 years and unable to cover their interest burden from operating results over three consecutive years.

Zombie companies typically experience a high degree of share price volatility, with their market value having fallen sharply over time. Their listed market value is likely to be below the value of their net tangible assets, and their operating cash flow is often negative.

The OECD’s own extensive research on the rise of zombie companies around the globe has found they are a key cause of reduced economic productivity.

The OECD argues for the need for policy changes to revive productivity growth by improving the design of insolvency regimes to accelerate the restructuring or exit of weak firms.

The importance of diversification

The increase in corporate defaults, and zombie companies, highlights the benefits of having good investment diversification, especially when it comes to owning shares.

One of the simplest ways to achieve that is through the use of broad market index funds, such as exchange traded funds (ETFs) and managed funds, which typically have shareholdings in hundreds and sometimes thousands of listed companies.

Rather than trying to guess which investments will outperform in the future, the managers of index funds seek to replicate a particular market or sector.

This means they invest in all or most of the securities in an index that corresponds with the investment purpose of the fund.

There are multiple benefits in using index funds, but most notably it’s for their diversification, because they invest in all or a representative basket of the securities that are included in an index.

This significantly reduces risk by leaving portfolios less exposed to the ups and downs of individual companies which may get into financial difficulty at some point in time, or to a smaller number of investment holdings.

With a broad range of assets in a portfolio, returns from better performing assets can help compensate for those not performing so well.

By investing in a range of index funds, investors can diversify their portfolios across different industries and securities, both in Australia and overseas.