Retail is the fourth largest exposure in US CLOs, according to a note from Deutsche Bank issued last week.
The note from the bank highlighted the sector as the largest credit concern in CLOs, following the issues seen in commodities and energy since the drop in oil prices in mid-2014.
Now that the energy sector has calmed somewhat, the focus in CLO credit has shifted to retail, given the sector's dwindling profits, high overhead costs and fierce competitive headwinds in the form of Amazon.
A quick look into the fourth quarter numbers of some of America’s largest retailers reveals the problems in the space are not going away.
The country’s physical retail behemoth remains Walmart, which, though it possesses a solid Aa2 rating, points the way to some of the problems experienced elsewhere. The retail giant’s numbers look good at first glance, with a 1.8% rise in sales, but this came at the expense of profit which fell by 18% in the quarter, as the company spent billions on price cuts, digital infrastructure and wages in order to compete with Amazon.
Other, more leveraged names, are having a tougher time. One of the more challenged retailers is clothing brand J Crew, which had loan obligations trading at an average price of 56 at the end of January.
Deutsche explained that CLOs have close to $400m of exposure to the company, making it one of the largest retail exposures in the market.
J Crew posted a third quarter 2016 loss of $7.9m and a 4.2% year on year revenue drop — J Crew is yet to post its fourth quarter earnings.
A CLO manager and investor talking to GlobalCapital about the retail space and J Crew in particular questioned whether companies that rely on seasonal fluctuations and the fickle clothing buyer habits “even be allowed to issue senior debt in the loan markets”.
A CMBS investor also said that he steered well away from the retail market for two reasons. Firstly because of the risks associated with terrorism, but also because of transient buyer habits.
“I don’t invest in retail because I don’t want to be taking a bet on the buying habits of teenagers,” said the CMBS investor.
Retailers have had years to come up with competitive strategies to take on the largest online retailers, in particular Amazon. But many have failed to react to a business model which has been eating at their profits for the best part of a decade, and this should worry any investor with a substantial level of retail debt in their CLO portfolio.
With retail leveraged loans repricing at a rapid rate, CLO issuers looking to aid deal economics could even add exposure to traditional retail names into CLOs in order to improve equity returns.
But investors should be wary. They are taking a gamble on a business that is under attack on all sides, struggling to adapt to the new environment, and is beholden to the whim of seasonal trends.
CLO managers have cycled out of oil credits, largely because oil prices remain such an uncertain bet, and they should consider doing the same with retail.