Goldman Asks: “Is This The Next Shoe To Drop”?

We’ve been over and over the retail “big short.”

To be sure, this is a “bigly” deal and something you should generally try to keep up to speed on even if you have no intention of trying to trade it. For those who missed them, here are the recent posts that will get you caught up:

Ok, so in addition to all of that, one of the topics we explored earlier this year is the extent to which, amid questions about commodities (which are now in the midst of a truly epic plunge) HY investors don’t really need another reason to think that what they’re holding is too rich. Or, put differently, that a decompression episode on the order of the mammoth spread compression we’ve seen over the last 14 months is in the cards.

Given that, this chart (which again, we highlighted months ago) is unnerving:

retailccc

See why that’s bad? It feels a lot like when US energy producers lost market access. 

Well anyway, Goldman is out on Friday asking a simple question: “is HY retail the next shoe to drop?”

We would say the answer goes something like this: “well Goldman, there are a lot of shoes dropping right about now, so we don’t know whether ‘next’ is accurate, but this is one shoe that probably will hit the ground at some point.”

You might also wonder, given the spike in correlations between copper/oil and HY during periods where the former selloff, what the potential knock-on effects for junk as a whole might be from a retail collapse.

Here are some excerpts from Goldman’s note that explore all of the issues mentioned above and more (aside: do note the chart that compares the spread ratios – that’s something we’ve flagged recently as important in the E&P context as those names don’t seem to be reacting – relative to HY spreads as a whole – the way they should during periods when crude sells off).

Via Goldman

In the current low vol regime, the US HY market has remained for the most part range bound, with spreads revisiting their post-crisis tights and any widening quickly mean reverting as capital continues to chase higher carry assets and sectors. Bracing for our key theme for credit in the second half of the year, we expect sector and bond-level dispersion to pick up, fueled by increased policy action and uncertainty along with greater investor focus on sectors facing secular challenges. We have already seen tentative signs of dispersion in HY, with $75 billion or 6.4% of the Yieldbook HY sectors trading wider than their 2-year medians compared to not a single sector in IG trading wide to this threshold.

Chief among the drivers of further dispersion? HY Retailers, a pocket of the market facing secular decline challenges as declining foot traffic, increased price transparency, and channel shifts to other formats (both discount and online) continue to put pressure on, especially, the brick and mortar retail credits. Retail stores are the only sector year-to-date to produce negative returns—down 0.1% and lagging the broader HY index by 3.5%—as retailers have resisted investors’ impetus to “buy the dip” in the overall tight spread environment.

Additionally, the number of CCC-rated retail and apparel issuers has tripled over the past six years, with the share of CCC issuers in the Retail sector rising to the highest level since the recession at nearly 14%, according to Moody’s calculations.

Since mid-April however, HY Retail spreads and the CMBX BBB- Series 6 index—a macro proxy to gain retail exposure—have tightened by 56bp and 39bp, respectively, but we would caution this relief rally appears technically driven due to short covering rather than a reflection of improving fundamentals. Expectations remain less positive for 1Q17, in our view, on the heels of a very disappointing holiday season, while longer-term demand trends are weakened by changing consumer habits, especially amongst Millennials. Despite the recent tightening, HY retail is still trading at a significant discount to the broader market (723bp vs. 404bp) as the compression in the HY index has more than doubled that of HY Retail since the local wides reached in February 2016. Exhibit 1 also puts into perspective the now greater spread pick up offered in HY Retail relative to the HY E&P and Metals and Mining sectors as shown by the sector vs. HY market spread ratio.

GSHYRetail

…but spillover of HY Retail to broader market is more limited vs. Energy. Although we see the secular challenges facing HY retailers remaining in place for the foreseeable future, we think the technical spillover and scope for any impact to the broader HY market will be more limited than HY Energy in the late 2015/early 2016 paradigm for three main reasons. First, the scale of the HY retail sector is significantly smaller with a total of $27.4 billion outstanding in the HY bond index—equivalent to only a 2.5% share on a market value basis—compared to $77 billion outstanding in the HY E&P sub-sector and $164 billion more broadly for HY Energy (for a combined 15% share); see Exhibit 2. Secondly, refinancing risk in the Retail sector remains manageable, with only 6% of the outstanding debt in the sector maturing over the next three years. And lastly, the fundamental weakness in the Retail space is better understood by investors in the context of physical store closings and the rise of online market share, while the drivers and the consequences of the New Oil Order were not immediately fully understood.

GSHYRetail2

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