This article is provided to FT.com readers by Debtwire—the most informed news service available for financial professionals in fixed income markets across the world. www.debtwire.com
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As the cost of credit default protection on financial services drops by the day, bearish investors are switching their sights to retailers, sending spreads on the sector soaring, several analysts, traders and fund managers told Debtwire. The sellside added fuel to the fire last week as banks long retail risk rushed to hedge their positions, said a buysider and a trader.
“Retail is the new short sector,” remarked a second CDS trader.
Just four short weeks ago, financials were the vogue trade. The cost of five-year default protection on Morgan Stanley languished in the 250bps range during the dog days of summer only to spike to 909bps in mid-September after Lehman filed for bankruptcy.
Spreads on the investment bank’s CDS ratcheted steadily higher – peaking at 1439bps on 13 October – before falling off a cliff to 500bps on the announcement of federal equity investments in the US banking industry, according to Markit. That volatility broadly mirrors the trading history of CDS written on all financials, a roller coaster ride that provided a bonanza for buyers who got in, and out, at the right time.
In the wake of the US government’s unprecedented capital injections, CDS for financials have become far less attractive, said two CDS traders, two CDS analysts and one buysider.
Fitch Solutions tracks the so-called relative differential of CDS on specific sectors by comparing the five-year CDS spreads of particular credits to companies trading with the same implied rating based off their spreads, regardless of industry. While that differential for financials spiked to over 21% at the height of the banking crisis, it has since retraced to 8%, according to the data provider.
Now that financials are last week’s play, investors are finding new blood in the retail space. And unlike the banking sector, retailers can’t count on any near-term catalysts, such as a bailout or M&A activity, to reel spreads back in, said the first buysider.
The cost of protection on retailers started to rise in September but didn’t spike until 8 October when department store chains Saks, Neiman Marcus, Dillard’s and JC Penney reported same store sales drops of 10.9%, 15.8%, 12% and 12.4%, respectively. The data cemented expectations that the holiday season would be joyless and investors piled into CDS across the sector.
Saks five-year CDS traded Wednesday at 23-25.5 points upfront as compared to 817bps on 7 October. Dillard’s protection was quoted Wednesday at 24bps-27.5bps upfront as compared to 910bps on 7 October. Neiman Marcus traded at 15.5bps-17bps upfront versus 700bps on 7 October.
Spread widening throughout the sector tapered off late last week as markets stabilized globally but that may not last, particularly once holiday numbers start rolling in, said one of the CDS analysts. While spreads on consumer goods CDS moved out around 10% last week, they remain only 8.23% wide of their historical average relative differential(ARD), compared to the 21% peak for financials earlier this month, according to Fitch Solutions.
Neiman Marcus’s ARD was 49.4% wider than the average for credits trading as if they are rated B, Liz Claiborne was 32.9% wider than the average for credits trading as if they are rated B plus, and Neiman Marcus was 24.5% wider than the average for credits trading as if they are rated B, according to an analysis provided by Fitch Solutions.
As the industry trades into a new range, relative spreads between single names CDS is changing dramatically. High-end department store chain Saks and mid-tier Dillard’s now trade in tandem although Dillard’s historically traded 100bps-150bps wide of its competitor, according to Markit. As the cost of protection on Saks spiked, the spread between its CDS and that of Neiman Marcus widened to 200bps after months of trading within 100bps, according to Markit.
Dillard’s unadjusted total leverage is currently 3.2x based on USD 369m of LTM EBITDA through 2Q08 and USD 1.18bn of debt, said a third sellsider. Saks reported leverage one full turn below that at 2.2x based on USD 255m of LTM EBITDA and USD 560m of debt. Neiman is 3.5x levered through its senior secured bonds based on USD 686m of LTM EBITDA and debt of USD2.45bn.
CDS on Dillard’s and Saks trade at far wider spreads than Neiman because their bonds are extremely illiquid, leaving swaps as the only vehicle to take a short position on their credit. Saks, for instance, has only USD 84m of its 8.25% senior notes left outstanding after buying back USD 96m of the bonds in 2Q07. Neiman’s, on the other hand, reported USD 1.2bn of senior and subordinated notes outstanding as of 26 April.
Another technical factor also contributed to the CDS buying frenzy. Some dealers were caught with long positions either through cash bonds or through selling protection going into the crisis of recent weeks. As credit committees forced those desks to hedge their exposures, dealers sent out increasingly wider runs on retailers en masse and, in some cases, began asking for points upfront, said the first trader and the first buysider.
Default risk for JC Penney, Macy’s, Limited Brands widened last weekend as a result, said the trader. Apparel manufacturer Liz Claiborne was also caught in the squeeze last Thursday as an interdealer trade caused a chain reaction, said the first buysider. Five-year CDS on the name spiked by as much as 200bps to 950bps last Thursday (16 October) before closing at around 850, he added.
Claiborne’s five-year CDS is offered at 780bps-800bps today. Protection for JC Penney has kicked out to 375bps-390bps today as compared to 200bps at the start of October.
With anticipation of bleak holiday sales the retail space is not going to recover anytime soon, so spreads will likely hang out at wider levels, said the first sellside analyst. And no white knights will be riding in to save the sector anytime soon, he added.” If you look at financials, there was so much activity to help them out,” he said. “In retail, you are not going to have government intervention.”
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