Giant tech firms like Uber and Tesla are lapping up junk debt, here's why investors are lining up to lend it

elon musk champagne

REUTERS/Noah Berger

Tesla CEO Elon Musk.

  • WeWork, Uber and Tesla are banking on their brand name appeal to pile on junk debt typically deemed too risky for lesser known peers with better credit.
  • Investors are eager to lend to them, favoring companies' potential over their underlying financial health, because those chasing yield haven't had a lot of choice lately.
  • "In general, unicorns don't belong in high yield," says one fund manager.

Some of the biggest darlings of the tech industry have joined Tesla recently in piling on cheap debt to fuel booming growth plans, relying on their size and brand-name appeal to secure funding typically deemed too risky for lesser-known peers with better credit.Advertisement

WeWork, rated B, (otherwise known as junk) issued a $702 million bond in April. Uber issued a $2 billion junk bond deal last month, despite rapid cash burn and growing competition. And while Tesla's precarious debt situation is nothing new, it's in a similar boat to the others. Tesla is giving some investors jitters because it has $1.6 billion of maturities looming over the next 12 months.

Investors are favoring companies' potential over their underlying financial health, in part because they're benefitting from the "halo effect" of their sexy, big-name brands, says Christian Hoffmann, a portfolio manager at Thornburg Investment Management.

It's a marked shift in the industry. Demand is growing, for now. But it's a risky scenario.

Unicorns don't belong

"In general, unicorns don't belong in high yield," said John McClain, a portfolio manager at Diamond Hill, a US investment firm that manages fixed-income funds. "Putting financial leverage on companies with high levels of operating leverage, minimal tangible assets, and/or the ability to generate cash flow is irresponsible."

Leverage refers to the amount of debt a company has amassed over its earnings. Having high leverage means a company has more debt than assets available to pay off debts at a given time.On the whole, investors tend to steer clear of companies that are highly leveraged or have far from robust credit metrics, says Christian Hoffmann, a portfolio manager at Thornburg Investment Management. Advertisement

Take WeWork: The company received $4.4 billion in investment from a major SoftBank fund last year but runs an "asset light" model because it leases most of its office space. Despite plenty of hype, the company posts loss after loss, and according to Moody's, is unlikely to turn a profit anytime soon.

In August, Moody's took the unusual step of withdrawing a B3 rating on the New York-based company, citing a lack of information. For bond holders, the company's limited assets make it a riskier proposition in repayment terms if things go south.

Chasing yield is getting tougher

Tesla's high leverage and cash burning activities have given some investors cause for concern because the company will eventually need some way of paying it off, and it's not clear it will be that easy. The company took its first foray into the junk bond market in August 2017 with a $1.8 billion issue.Advertisement

WeWork declined to comment for this story. Uber and Tesla didn't respond to requests for comment.

Bond investors chasing yield haven't had a lot of choice lately. But they have found a home in this part of the market. With high return comes more risk, though. A set of poor earnings could lead to declining confidence from lenders and greater scrutiny of the market. Throw in a US recession, and things could get very, very bad.

These companies and other unicorns tend to be "highly reliant on capital markets and have very pressing debt issues," McClain said. Advertisement

And then there's Uber's. Its $2 billion bond deal last month was compared to deals by WeWork and Tesla, because of the company's rapid cash burn as competition heats up with rival ride hailer Lyft. Uber lost an eye-watering $4.5 billion in 2017. The company was able to issue its bonds via a private placement, allowing it to bypass the Securities and Exchange Commission's reporting requirements.

So-called "leveraged loans" have garnered a lot of negative attention lately, with former Federal Reserve Chair Janet Yellen and the Bank of England among those sounding the alarm on their potential risk. But the $1.6 trillion market is hot nonetheless: Responding to strong demand, Uber also raised a $1.5 billion leveraged loan directly from investors in March, a higher amount than the company had originally planned.

Leveraged loans differ from high-yield bonds in that they are secured, meaning creditors are paid before bondholders. Volumes have spiked in recent years with covenants protecting lenders from defaults deteriorating over this period, making the loans more akin to bonds.Advertisement

McClain said that the high-yield market has been lucrative to tech stocks because financing has tended to be cheaper and more effective than selling more stock.

The message is clear: If you're a big-name tech company with even bigger ambitions, investors are lining up to lend to you.Get the latest Tesla stock price here.Advertisement