With the critical holiday season fast approaching, some fixed-income investors are hedging against the risky mall sector, seizing on opportunities in the CMBX and in credit default swaps to bet against retail, according to an investor, three research analysts, a trader and a data provider.
Retailers have been battling headwinds from the Toys “R” Us bankruptcy to a steady drumbeat of Sears closures as the industry faces declining sales, competition from online sellers, and a survival-of-the-fittest mentality in multi-mall markets. Investors are betting against the sector by taking short positions on the CMBX 6 and 7 junior tranches, buying CDS protection on retailer and mall REIT bonds, and outright shorting those companies’ stocks, sources said. A small group of investors have been buying retailer CDS for at least 12 months, one trader said.
“Nobody feels great about retail and it’s a question of whether it’s a fairly priced trade,” said Manus Clancy, senior managing director at Trepp. “I think [investors] are watching the corporate bond prices, they’re trying to get their arms around this well in advance. … The savvy guys are thinking about this three steps ahead, like a chess player.”
In mid-September, bearish investors sent spreads on the CMBX 6 and 7 junior tranches to their widest levels in at least a year. Spreads on the CMBX 6 BB tranche reached 1,191bps on 19 September, up from 1,085bps on 31 August, according to data from JPMorgan. Levels narrowed in early October, but another round of widening blew out spreads on the tranche to 1,190bps on 24 October.
CMBX spreads could widen further, according to Edward Reardon, analyst at Deutsche Bank, who initially called for shorting the CMBX 6 BBB- and CMBX 7 BBB- tranches in a 7 February report. The tranches were selected due to their higher exposure to weak retail and greater seasoning. Reardon noted that several factors remain at play, including that CMBX spreads are extremely levered to bond principal writedowns and that investors will demand a much higher spread premium as subordination shrinks.
“These bonds have a lot of idiosyncratic exposure through these malls,” he said. “If you lose your enhancement at this point in the capital structure, your risk premium goes up exponentially.”
He pointed to a recent widening in the CMBX 6 A tranche, a notch up from the typical trades in the BBB- and BB tranches, as a sign of growing investor interest in the short trade. Spreads on the tranche widened 46bps in early September to reach 338bps on 19 September, the widest in at least a year, according to JPMorgan data. Spreads later narrowed to 309bps on 24 October.
“If you start seeing volatility at the A level, that means there are guys out there that think losses won’t be contained to the low single digits,” Clancy said.
While most investors are anticipating further distress in the retail market, the debate over exactly the best way to hedge against it has been ongoing this year, gaining momentum with each new store closure or bankruptcy headline.
One flashpoint in the debate was a 5 April Citigroup report that argued against the CMBX short approach, noting that the trade had gotten too crowded, especially in the CMBX 6 BBB- tranche.
Despite recent widening in that tranche, Citi stands by its call. It’s too early to determine which route has succeeded, said Anindya Basu, director of credit derivatives strategy with Citi Research, who co-authored the report. Shorting retailers is a more long term play, he said, but it is a more direct means of protecting against the decline of retail which he expects to play out over a long period.
“It’s a slow moving train wreck and if I have to choose to hold something long-term I’d rather choose something that is cheaper,” Basu said. Mall closures are a “second-order effect” of retail decline and the properties’ demise may be cushioned by efforts to repurpose them as other types of properties or leasing space to such previously non-typical mall users such as grocers, Citi said.
Still, some of the more troubled retailer names are getting more expensive as retail risks are mounting.
For instance, the CDS market is pegging a 64% probability of a bankruptcy or other credit event for Sears over the next year, based on IHS Markit data as of 20 October, up from 36% at the end of 2016. The upfront cost of buying credit default protection on USD 10m notional in Sears debt for one year rose about threefold to USD 3.79m as of 20 October from USD 1.76m at the close of 2016, according to IHS Markit. At the same time, spreads on Sears one-year CDS have also soared to 6,020 as of 20 October from 2,731 at the close of 2016. “That’s one of the most distressed credits in the marketplace,” said one market participant.
CDS of some other retailers haven’t moved as much. Spreads for one-year credit default protection on USD 10m notional of Staples debt ticked up to 81 as of 20 October from 20 at the close of 2016, according to IHS Markit. The probability of a Staples bankruptcy or credit event over the next year was 2% as of 20 October, up from 0% at the end of 2016. Staples was included in a basket of retail names that Citi’s April report proposed shorting, but Sears was not.
One CMBS investor said he thinks that the CMBX short trade is “finished for now, it’s been priced in, unless you get more bad news.” He noted that Sears recently received funding that will help ease its pain, at least in the short term. The firm borrowed an additional USD 140m from ESL Investments earlier this month, as reported (see story, 5 October).
There’s a belief in the market that a number of malls will be able to “muddle through” their issues, said one New York-based debt advisor. Even properties identified as “at risk” are mostly performing well on paper, with a DSCR above 1.1x, he said. Malls owned by strong developers, those with the wherewithal to re-tenant them, are especially likely to make it through unscathed.
“I think the sentiment is that, yes, there’s a lot of trouble, but a lot will muddle through,” he said. “It will take a long time to profit from that trade.”
Investors are watching a series of upcoming CMBS 2.0 mall maturities for clarity on the health of the market, sources said. Among them is the USD 67m Fashion Outlets of Las Vegas loan, located in Primm, Nevada, from COMM 2012-CR4, which is held in special servicing and matures in November, according to a 15 September Trepp note.
“[The short trade] kind of went away for a while and there were three 2.0 malls transferred because of maturities, and that renewed the pressure,” said a second CMBS portfolio manager. “If these three loans take losses, then it indicates that there’s still risk out there.”
The news of the Fashion Outlets mall transfer coincided with the mid-September widening in CMBX spreads. But the transfers aren’t a clear win for the short holders, Clancy said. It’s possible that a workout could end in a maturity extension, which would accrue to the long holder’s benefit.
“We think people will see those loans as troubled, as unable to refinance, and adjust their expectations around those loans and loans that look like that,” Reardon said. “It’s really a marker for what the refi environment looks like.”
Investors are also closely watching the USD 141.8m Westside Pavilion loan, backed by a mall in Los Angeles, California, in WFCM 2012-LC5 that transferred to special servicing in September due to performance issues. While the mall’s loss of Nordstrom to nearby Century City is expected to lead to further deterioration of NOI, there is upside potential in the property which could be redeveloped, according to a 22 September Morgan Stanley report. Absent a repositioning, the mall’s outlook is concerning, analysts wrote.
Looking ahead, fourth quarter results are going to be a “big moment” for retailers, who have a lot to prove following a dismal 2016 holiday season, Reardon said. He recommends that investors watch for retailers including the major department stores, Foot Locker, Lane Bryant-owner Ascena Retail Group, Victoria’s Secret-owner L Brands, and Kay Jewelers-owner Signet Jewelers.
In addition, many eyes are on Sears, scrutinizing whether it will file for bankruptcy protection sooner rather than later to avoid having to slog through the holiday season, according to a retail real estate consultant.
“It feels like the dot-com era a bit,” Clancy said. “Everyone thinks there will be a shakeout and everybody wants to see the next guy’s earnings. It’s an interesting time.”