Retail Debt Debacles

The retail sector has replaced the oil sector in a sense, and not in a good way. It is the sector that is most likely to see a large surge in bankruptcies this year. Junk bonds issued by retailers are performing dismally, and within the group the bonds of companies that were subject to leveraged buyouts by private equity firms seem to be doing the worst (a function of their outsized debt loads). Here is a chart showing the y-t-d performance of a number of these bonds as of the end of March:

 

Returns of several of the worst performing junk bonds issued by retailers in Q1 2017. This is rather impressive value destruction for a single quarter – click to enlarge.

 

Note the stand-out Neiman Marcus, a luxury apparel retailer, the bonds of which have been in free-fall this year. The company was bought out in an LBO and was saddled with a mountain of debt in the process. Investors buying this debt have now come to regret their purchases, particularly as it is debt of the “creative” kind.

Investor demand for junk bonds continues to be brisk, with inflows from retail investors said to be particularly strong. As we have pointed out on previous occasions, this surge in demand has resulted in creditors accepting ever softer loan covenants.

A long period of extremely low interest rates not only leads to a pronounced distortion of relative prices and the associated malinvestment of capital, it also tends to make a growing number of debtors increasingly vulnerable to rising rates and other disruptions. Over time, the number of companies forced to regularly roll over debt if they want to remain among the quick will inevitably increase.

These companies then depend on high investor confidence, which is now faltering in the retail sector. The out look seems appropriately grim: Fitch expects the default rate in the sector to spike to 9% this year.

 

Yields on junk bonds issued by retailers have begun to diverge rather noticeably from yields on the broader junk bond universe this year – which is reminiscent of oil sector junk bonds in 2014 – click to enlarge.

 

Ponzi Instruments

One of the innovations created in order to exploit the mindless yield-chasing by investors are so-called PIK toggle bonds (PIK= payment in kind), which essentially represent Ponzi finance instruments.

The term “Ponzi finance” was coined by post-Keynesian economist Hyman Minsky. We think his financial instability hypothesis is descriptive rather than explanatory, but we don’t want to focus on Minsky’s theory. Still, it is at least worth noting in passing that he ultimately argued in favor of even more government intervention, so he basically just recast the old “market failure” fairy tale.

 

Left: famous early 1920s fraudster Charles Ponzi at the height of his career, shortly befor his actions brought down six banks in the Boston area and impoverished thousands of gullible investors. Right: post-Keynesian economist Hyman Minsky, who used Ponzi’s name to describe a certain type of borrower in the framework of his “financial instability hypothesis”.

Photo via Boston Public Library / Levy Economics Institute of Bard College

 

Anyway, Minsky differentiated between three types of borrowers one can observe in the “stable” period (i.e., in the boom phase): 1. hedge borrowers, who are able to meet all their debt obligations from cash flows; 2. speculative borrowers, able to pay interest out of their cash flows, but unable to meet redemptions of principal without issuing new debt; and 3. “Ponzi borrowers”, who aren’t even able to meet interest payments on their debt without issuing more debt.

In this sense, PIK toggle bonds are clearly instruments of Ponzi finance. Issuance of PIK bonds briefly stalled in 2015, presumably because concerns over China’s declining foreign exchange reserves and rising stock market volatility spooked investors. It recovered with a vengeance in 2016:

 

In 2016 PIK toggle bond issuance was almost back at the record set in 2014 – click to enlarge.

 

As their name indicates, these bonds allow issuers to choose whether they want to pay interest in cash, or by simply issuing more of the same bonds to bondholders. Once the second option is chosen, one can be fairly certain that the issuer is in trouble or fears he soon will be, and is scrambling to preserve short term liquidity. And that is precisely what Neiman Marcus has just done. As Marketwatch informs us:

 

“A rolling loan gathers no loss. That appears to be the adage guiding upscale department-store chain Neiman Marcus, which has opted to make the coming interest payments on its high-yield bonds by issuing more debt, instead of burning through cash. The company said it was electing the payment-in-kind (PIK) option on its $600 million in 8.75% notes due to mature in 2021 for the coming six-month coupon period through Oct. 14, according to a filing with the Securities and Exchange Commission. The move is aimed at enhancing its liquidity, the Dallas-based company said. It will pay PIK interest at a rate of 9.50% for the interest period, which started on April 15. The current yield on the benchmark 10-year Treasury is just 2.20%.

Neiman had $105.8 million in cash and cash equivalents on hand as of April 1, and has $423.2 million of unused borrowing available under its $900 million asset-based revolving credit facility, according to the filing. The bonds in question were quoted at 56.75 cents on the dollar on Wednesday, according to MarketAxess. Like many retailers, Neiman has struggled with changes impacting the industry, from weak mall traffic to evolving consumer behavior to intensifying competition from juggernaut Amazon.com Inc. In February, S&P Global Ratings cut the company’s rating by three notches to CCC-plus, placing it deep into junk territory, citing a poor operating performance.

(emphasis added)

 

Perhaps Neiman Marcus serves as a kind of canary in the coal mine for the retail sector now (or at least the apparel sub-sector), but this is not the first time it has used the “toggle” function of its PIK bonds. What makes this instance stand out a bit is that it happens after a very persistent downtrend in same-store sales (five quarters in a row).

As the first chart shows, apparel chains are evidently not the only brick and mortar retailers in trouble. Moreover, if the default rate forecast by Fitch turns out to be correct, there should be a significant impact on the commercial real estate business down the road. A great many shopping malls are bound to turn out to be surplus to requirements. As an aside to this, we suspect that quite a few office towers will eventually become obsolete as well.

 

A glimpse of the future?

Photo credit: Seph Lawless

 

Clusters of Errors

In the excerpt from the Marketwatch article above it is inter alia pointed out that the company and many of its peers are “struggling with changes impacting the industry”. That almost sounds like a report on a ship that is about to capsize because its crew was surprised by inclement weather and high waves.

That is not really the case here though; these problems are not akin to a natural catastrophe. Whenever large clusters of business errors emerge in a sector of the economy, one must wonder how this is even possible (that applies to the recent problems in the energy sector as well). Are that many businessmen and investors  involved in the sector so bereft of foresight that they could not see this coming?

That seems rather unlikely; it seems far more likely that their decisions were somehow led astray. The culprit at the top of our list is the fact that in the past eight years alone, the Federal Reserve has aided and abetted the creation of ~7.35 trillion dollars in new money in addition to the 5.3 trillion dollars that existed in early 2008.

 

US broad true money supply TMS-2: when the money supply is expanded by 140% in eight years, stuff happens. It feels good at first, but illusory profits and phantom wealth always disappear down the road, one way or another – click to enlarge.

 

As we have recently discussed, money supply growth is currently falling quite rapidly – we expected growth in the broad true money supply to follow the lead of AMS, and that is now indeed happening. Without QE, money supply expansion has become relinked to growth in commercial bank credit, which is rapidly declining lately – and money supply growth has followed suit. We have to expect a further slowdown in economic activity in coming months as bubble activities begin to be liquidated (bubble activities are economic activities that would not take place without monetary pumping, as they are not really profitable).

 

Year-on-year growth rate of TMS-2 and total bank credit. The current TMS-2 growth rate of 6.12% is the lowest since October 2008, when the Fed’s various debt monetization schemes began to take off – click to enlarge.

 

Conclusion

More errors will likely be unmasked as the year progresses. Not only that, it seems we will finally find out what threshold in the money supply growth rate needs to be undercut in the post-QE era for the bubble in asset prices to burst.

PS: The fact that the companies with the biggest problems were taken over in LBOs by private equity firms is a topic we will discuss in more detail a separate post. We can tell you already though that the data indicate that in the not-too-distant future many investors are going to feel as though they have been transported to hell and eventually, even Crispin Odey’s loneliness will end.

 

Charts by: Bloomberg, St. Louis Fed

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

One Response to “Cracks in Ponzi-Finance Land”

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • America Goes Full Imbecile
      Credit has a wicked way of magnifying a person’s defects.  Even the most cautious man, with unlimited credit, can make mistakes that in retrospect seem absurd.  But an average man, with unlimited credit, is preeminently disposed to going full imbecile.   Let us not forget about this important skill...  [PT]   Several weeks ago we came across a woeful tale of Mike Meru.  Somehow, this special fellow, while of apparent sound mine and worthy intent, racked up...
  • Retail Capitulation – Precious Metals Supply and Demand
      Small Crowds, Shrinking Premiums The prices of gold and silver rose five bucks and 37 cents respectively last week. Is this the blast off to da moon for the silver rocket of halcyon days, in other words 2010-2011?   Various gold bars. Coin and bar premiums have been shrinking steadily (as have coin sales of the US Mint by the way), a sign that retail investors have lost interest in gold. There are even more signs of this actually, and this loss of interest stands in stark...
  • Credit Spreads: Polly is Twitching Again - in Europe
      Junk Bond Spread Breakout The famous dead parrot is coming back to life... in an unexpected place. With its QE operations, which included inter alia corporate bonds, the ECB has managed to suppress credit spreads in Europe to truly ludicrous levels. From there, the effect propagated through arbitrage to other developed markets. And yes, this does “support the economy” - mainly by triggering an avalanche of capital malinvestment and creating the associated boom conditions, while...
  • Gold Divergences Emerge
      Bad Hair Day Produces Positive Divergences On Friday the ongoing trade dispute between the US and China was apparently escalated by a notch to the next level, at least verbally. The Trump administration announced a list of tariffs that are supposed to come into force in three week's time and China clicked back by announcing retaliatory action. In effect, the US government said: take that China, we will now really hurt our own consumers!  - and China's mandarins replied: just you wait, we...
  • Industrial Commodities vs. Gold - Precious Metals Supply and Demand
      Oil is Different Last week, we showed a graph of rising open interest in crude oil futures. From this, we inferred — incorrectly as it turns out — that the basis must be rising. Why else, we asked, would market makers carry more and more oil?   Crude oil acts differently from gold – and so do all other industrial commodities. What makes them different is that the supply of industrial commodities held in storage as a rule suffices to satisfy industrial demand only for a...
  • Chasing the Wind
      Futility with Purpose Plebeians generally ignore the tact of their economic central planners.  They care more that their meatloaf is hot and their suds are cold, than about any plans being hatched in the capital city.  Nonetheless, the central planners know an angry mob, with torches and pitchforks, are only a few empty bellies away.  Hence, they must always stay on point.   Watch for those pitchfork bearers – they can get real nasty and then heads often roll quite literally....
  • Lift-Off Not (Yet) - Precious Metals Supply and Demand
      Wrong-Way Event Last week we said something that turned out to be prescient:   This is not an environment for a Lift Off Event.   An unfortunate technical mishap interrupted the latest moon-flight of the gold rocket. Fear not true believers, a few positive tracks were left behind. [PT]   The price of gold didn’t move much Mon-Thu last week, though the price of silver did seem to be blasting off. Then on Friday, it reversed hard. We will provide a forensic...
  • Cryptocurrency Technicals – Navigating the Bear Market
      A Purely Technical Market Long time readers may recall that we regard Bitcoin and other liquid big cap cryptocurrencies as secondary media of exchange from a monetary theory perspective for the time being. The wave of speculative demand that has propelled them to astonishing heights was triggered by market participants realizing that they have the potential to become money. The process of achieving more widespread adoption of these currencies as a means of payment and establishing...
  • The Fed's “Inflation Target” is Impoverishing American Workers
      Redefined Terms and Absurd Targets At one time, the Federal Reserve's sole mandate was to maintain stable prices and to “fight inflation.”  To the Fed, the financial press, and most everyone else “inflation” means rising prices instead of its original and true definition as an increase in the money supply.  Rising prices are a consequence – a very painful consequence – of money printing.   Fed Chair Jerome Powell apparently does not see the pernicious effects...
  • Merger Mania and the Kings of Debt
      Another Early Warning Siren Goes Off Our friend Jonathan Tepper of research house Variant Perception (check out their blog to see some of their excellent work) recently pointed out to us that the volume of mergers and acquisitions has increased rather noticeably lately. Some color on this was provided in an article published by Reuters in late May, “Global M&A hits record $2 trillion in the year to date”, which inter alia contained the following chart illustrating the...

Support Acting Man

Item Guides

j9TJzzN

The Review Insider

Dog Blow

Austrian Theory and Investment

Archive

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com