In this month's LDI market commentary:
• July’s rallying bond market activity
• The outlook for the retail sector
July’s Bond Market Activity — rates rallying, yield flattening
July started where June left off — with rates rallying and the yield curve flattening. Oddly, while reported inflation data validated this trend, Treasury markets were turning around, reversing July’s move and then retracing over half of June’s activity. Economic releases in the U.S. and abroad showed steady growth at a moderate level. Central bank comments indicated a desire to remove QE but with a recognition that caution was necessary.
Ten-year Treasury yields fell 1 basis point to 2.29% while 30-year Treasuries rose 7 basis points to 2.90%. Investment-grade credit spreads tightened 5 bps for the month. Utilities showed the most consistent strength.
Sector Outlook — Retail
LDI managers maintain a cautious outlook on the U.S. retail sector. Brick-and-mortar retail stores are under pressure like never before. Although the trend began two decades ago, internet commerce has changed the retail landscape in a profound way and at an unprecedented speed over the past couple of years.
While many retailers have navigated a history of cyclical pressures ranging from soft economies, swings in real estate valuations, supply-chain disruptions and evolving consumer behavior, today’s environment is different. Along with those challenges, even the largest retailers are struggling with structural fissures that have resulted in the shuttering of many stores (with more to come) and a wholesale rethinking of traditional business models.
Not all retailers face gloom and doom, but many are struggling. Within the context of an underlying market landscape characterized by low interest rates and relatively tight bond spreads, LDI managers take a cautious approach to investing in bonds issued by investment-grade retailers.
The rise of e-commerce has forced many brick-and-mortar retailers to shrink their physical footprints while shifting more business online. In addition, other unwelcome factors have arisen across many developed markets, such as anemic wage growth, altered consumer behavior since the great financial crisis (e.g., consumers hooked on discounts) and the growing impact of millennials with diminished brand loyalty.
The Impact of E-commerce on Brick-and-Mortar Stores
E-commerce has brought two clear structural changes, which have both directly and indirectly impacted the balance sheets, credit profiles, and valuations of retail companies. One major change is greater price transparency, which has put pressure on the margins of many brick-and-mortar retailers since they have a relatively higher fixed-cost base than their online peers.
The second major effect is the reshaping of traditional business models. Most large retailers have been actively managing their real estate with a view to closing underperforming stores, maximizing investments in good locations, and improving distribution and warehouse capabilities. Many companies are in the early stages of a longer term effort to grow their online businesses, while strategically repurposing their physical stores to support an omni-channel sales approach.
Across the retail sector, the impact is uneven. The least affected retailers thus far are deep discounters, such as Dollar General and T.J. Maxx. Other less impacted subsectors include large home improvement retailers, such as Home Depot and Lowe’s, and aftermarket auto parts stores like AutoZone.
Meanwhile, the retail grocery segment also is changing rapidly. Amazon is only one of many competitors, with most large grocers (including Wal-Mart as the largest) attempting to develop effective online platforms while trying to address changing consumer preferences. Worst hit by the e-commerce storm are office supply and department stores, which have seen meaningful deterioration in their financial performance and credit ratings.
The implications for LDI investors
In summary, structural transformation and heightened credit risks persist for many investment-grade retailers at the same time as many bonds are approaching historically rich valuations. In the absence of adequate compensation to bond holders for the spectrum of risks, LDI managers continue to take a highly selective approach to investing in this evolving retail universe.
(Portfolio manager Andy Barth and analyst Steven Lotwin contributed to this report.)