WeWork and Other Junk
Key takeaways:
• WeWork exemplifies the typical borrower in the high-yield bond market that is vulnerable to even the slightest economic shock. • The defaults and losses in this market will bleed into the banking system because lenders and businesses connected with borrowers are overleveraged.
• Despite rising risks, corporate bond yields are declining, which is typical end-of-cycle behavior (in search of yield, investors put money in the riskiest places).
• Even investment-grade corporate bonds are no longer safe, with more than half of them being rated BBB, which is one step above junk.
• As the sell-off begins, covenant-lite conditions and the forced selling of high-yield bonds by institutional investors will spark a massive liquidity storm.
• The collapse of high-yield debt will have a similar result to the subprime mortgage crisis in 2008.
In the previous two chapters, I talked about potential problems in the high-yield bond market. That’s the polite name for “junk” bonds, issued by companies that can’t earn an investment-grade rating even from our famously lenient bond rating agencies. This is a two-layer threat. First, many of these companies are so marginal that even a mild economic downturn could render them unable to make bond payments.
Next, bondholders will want to sell those bonds, but the liquidity they presume probably won’t be there. I could point to many examples, but we’ll take one that I think reflects the issue best: WeWork. The still-private company issued bonds last year, giving the public a peek into the books. The offering raised $702 million at 7.875%—a nice yield if it lasts the full seven-year term. That is, if you get your capital back at the end of those years. I’m not convinced investors will. I have to admit WeWork has a clear business model, one proven by other companies, and it is executing that model with panache and flair. The company signs long-term leases for office space, then subleases to the hordes of freelancers and independent contractors who need an inexpensive workspace. Much of it is just tabletop space in open suites. The risk is that WeWork’s renters could disappear quickly if their own income dries up, as will happen for many when the economy breaks. Investors seem to believe this risk isn’t just manageable, but negligible. So, if WeWork’s renters disappear, the first victims will not be WeWork, but the property owners who leased space to WeWork. They may have little recourse. But they’re probably leveraged themselves, so the losses will flow upstream, eventually to the banking system. And we know where that ends. Here’s the truly scary part: WeWork isn’t unusual. The landscape is littered with similarly tenuous corporate borrowers. It is the inevitable consequence of a free-cash decade.
Yields Act Crazy
There’s something else interesting and a little counterintuitive. You might think the yield on bonds issued by risky companies would rise as the cycle matures. That would be consistent with investors demanding more compensation for their risk. But it hasn’t happened that way.
After spiking higher during the 2015–2016 oil bust, when many shale drillers had serious problems, yields dropped in 2017. Not by coincidence—that’s also when the Federal Reserve began hiking rates every quarter. Fearing capital losses, Treasury investors relaxed their credit standards and created more demand for junk bonds, which sent those yields lower. That’s my theory, at least.
We’re seeing classic end-of-cycle behavior: throw caution to the wind and plunge capital into the market’s riskiest corners. This artificially induced buying is propping up companies that would otherwise succumb to the fundamental forces arrayed against them. Nor is it simply a junk-bond problem; the investment-grade corporate market is becoming measurably riskier too.
Almost half of investment-grade companies are rated BBB, just one step above junk, up from just one-third in 2009. When the economy breaks, some of those companies will run into trouble. Some of them will get downgraded, which will force many funds to sell them. This will further intensify the liquidity storm I’ve described. A few companies will probably default. Bondholders may have little recourse to recover their principal, having accepted covenant-lite conditions and taken on leverage themselves.Leveraged lenders will be in a pickle when the defaults begin, but they won’t be the only ones. It all flows downstream. Whoever extended credit to leveraged loan buyers will be in trouble as well. That’s how problems in one market spread to others.
The $2 Trillion Threat
My data sources show different amounts of high-yield bond issuance, but all show a lot of it. Some of these funds are well managed, and others are so large, they buy anything (maybe including WeWork) because they need to invest their incoming cash. Those numbers don’t count high-yield bonds held outside of funds and ETFs. According to the National Association of Insurance Commissioners, the insurance industry has $240 billion worth of high-yield debt, which represents 5.9% of their total bond investments. Then there are pensions, foundations, and endowments that have their own exposure to highyield bonds. The $2 trillion+ in high-yield bond funds and ETFs get marked-to-market every day, so individual investors can see their values go down as well as up. If losses cause enough of them to withdraw, it will force those funds to sell into a shrinking market, putting further pressure on valuations. In a plunging market, you don’t sell what you want, you sell what you can. Funds have to meet redemptions. That means increasingly lower-rated bonds remain for investors who don’t move early. Valuations drop, and it just cascades. A decade ago, we saw a subprime mortgage debt crisis bleed into the rest of the markets. I think this time, the high-yield debt crisis will have the same result.
My add: You see how redemption risk and liquidity risk play out
