An economic paradox is unfolding before our eyes. For more than a year, restaurants, hotels and other service sector businesses have either been forced to close or have drastically reduced revenues due to advancing lockdowns. But when we pass, let’s say, a large hotel chain, the lights still seem to be on. Unless we assume these companies have discovered a way to turn lead into gold, we may wonder where the money comes from.
To answer this question, we need to dive deep into the financial markets. In a dark corner of these markets, we find an asset class known as “junk bonds”. Junk bonds — sometimes politely called “high yield bonds” — typically have very high interest rates and low credit ratings. This means that the companies that issue the bonds are seen by investors as having a high probability of going out of business, so companies pay very high interest rates to borrow money. The junk bond market works because investors can tolerate the very high default rate due to the high interest rates paid.
Since March last year, when the lockdowns began, the junk bond market has gone crazy. Usually, the interest rate in the market increases as the number of bankruptcies increases. In March last year, bankruptcies skyrocketed and junk bond yields soared. But then something strange happened. Bankruptcies remained high, but junk bond yields fell to historic lows. Why?
There seem to be two forces at work. The first is the Federal Reserve. With the onset of lockdowns, the Fed has embarked on its most dramatic and far-reaching asset purchase program to date. Unusually, it even plunged into the junk bond market, something previously unimaginable. Meanwhile, after a brief crash, the financial markets began to blur. Soap bubbles have started to swell market after market: We all see chaos in the Bitcoin market, but many don’t know that the S&P500 is now more overrated than at any time since the dotcom boom in the late 1990s and early 1990s. 2000.
The second is that when the markets get manic, investors are hungry. They are trying to pump more and more money into more and more markets. Caution is thrown to the wind. Risky assets are collected as if they were gold US Treasuries. The Fed’s willingness to enter the junk bond market gave manic investors the excuse they needed. They piled up and drove lending rates to historic lows, even though foreclosure rates remained high and had clear potential to rise.
In March 2021, the Bank for International Settlements released a document that received too little attention. The authors found that too few companies went bankrupt relative to the magnitude of the economic crisis. They dug into why this was, and lo and behold, they found that companies are tapping into the credit markets. They borrowed to keep the lights on. In particular, they found that the high-risk companies were in the “aviation, hotel, restaurant and leisure sectors,” all those sectors that were hit hard by the blockades.
Looking at the research and the markets, it turns out that investors have some sort of reason for this massive wave of historically low interest rate loans. They seem to assume that the post-COVID backlash in the service sectors will be nothing short of magical. But even thinking about it for a moment suggests that this justification doesn’t make sense.
First, there is the question of whether vaccines will bring the long-awaited return to normal. The effectiveness of the vaccine appears to decrease over time. Some still hope vaccines prevent another shutdown this winter, but examples like Florida are throwing cold water on those ambitions. In Florida, over 80% of the vulnerable population is fully vaccinated, but there have been hospitalizations this summer that rival pre-vaccinated peaks.
But assuming vaccines can keep the virus in check, would we really see the service sector recovery the markets are hoping for? It seems unlikely. Many people are really terrified of this virus, some in a totally irrational way. It can take years for those people to get their lives back on track. This means that affected sectors will see fewer customers than before the pandemic. That doesn’t bode well for a recovery in the sector.
So what if the markets became less optimistic, junk bond yields rose and we saw a wave of defaults? Something very similar to what happened in 2008 in the mortgage-backed securities market. Bonds that investors consider relatively safe would turn into toxic sludge and whoever holds them would lose their shirt. Meanwhile, in the real economy, companies that eventually went out of business are laying off their staff.
Running a few numbers on this possibility yields terrifying results. Vulnerable sectors — real estate and construction — accounted for about 3% of total employment in the United States in 2008. The current vulnerable sectors — leisure and hospitality, aviation, art and recreation — account for more than 5% of total employment. It is true that in a massive bankruptcy scenario, the layoffs this time around may be less severe than in the real estate sector in 2008, but the fact that there is a larger pool to pull from should make us nervous.
What would cause such an accident? A mouse to scare off the market elephant. Markets are almost certainly in the late stages of a bubble. At some point, something will scare them. Maybe a little more inflation; perhaps the threat of a Fed rate hike; or perhaps a long-term inability to control the virus. Your guess is as good as mine. But what goes up must come down. And if that goes down, it seems likely that the junk bond market will come. Then we might have to deal with another large-scale financial crisis. Belt inside.
