By Ben Eisen
Credit markets tend to be segmented by how well underlying bonds are performing. There are the blue-chip corporate bonds that are making timely payments with little risk of default — the Apples /quotes/zigman/68270/delayed /quotes/nls/aapl AAPL and General Electrics /quotes/zigman/227468/delayed /quotes/nls/ge GE of the world.
Then there are the distressed credits that are not performing and often result in a bankruptcy or other type of restructuring. Think American Airlines Group Inc. /quotes/zigman/24849617/delayed /quotes/nls/aal AAL when it was under court protection.
But between those two silos lies the stressed sector, which Barclays strategists say may be ripe for opportunity. And a number of those high-yield names poised for a jump higher in prices are retailers.
Let’s be clear that such bonds aren’t for the faint of heart. It takes careful analysis to sift through the different risks to final repayment on the bonds. But where there’s risk there’s also opportunity. Bradley Rogoff, head of U.S. credit strategy at Barclays, leads a team of researchers who conclude:
“Within the credit market, performing and distressed are well-understood states for issuers. Stressed, on the other hand, is a more nebulous and transitory condition that we think creates unique opportunities for credit investors.”
Here’s the crux of the “transitory” nature of those bonds: 80% of those trading at an option-adjusted premium of 800 to 1,200 basis points above comparable Treasurys either see those premiums shrink or grow within 12 months, Rogoff writes. But there’s a “strong bias” toward shrinking (see chart at left), and stressed names tend to move in unison. That means prices could rise and yields fall, increasing the value of the bonds.
There are a bunch of retail and consumer names in this group of credits, including J.C. Penney Co. Inc. /quotes/zigman/237947/delayed /quotes/nls/jcp JCP , Sears Holding Corp. /quotes/zigman/95136/delayed /quotes/nls/shld SHLD , and private-equity-backed Toys ‘R’ Us (see below).
Based on this, Rogoff has a couple of trading suggestions:
“We retain long-term concerns about many of these companies, but see opportunities to get long certain parts of the capital structure of these names to take advantage of the typically positive return profile of this bucket: selling 1y CDS in [Sears] and [J.C. Penney]; pairing a long position in JCP 6.375s of 2036 or JCP 7.4s of 2037 with a short in the 7.95s of 2017; improving convexity by swapping out of the [Toys 'R' Us] 10.375s of 2017 and into the [Toys 'R' Us] 7.375s of 2018; and buying the [Sun Products ] 7.75% senior notes due 2021 and [Visant] 10% senior notes of 2017.”
Generally speaking, companies that issue high-yield bonds have been able to bolster their balance sheets in recent years by issuing debt at historically low rates. As Federal Reserve bond-buying stimulus pushed investors into the riskier reaches of the bond market, companies were able to take advantage of higher demand to borrow at lower rates. But that narrative doesn’t fit every company, says Jody Lurie, corporate credit analyst at Janney Capital Markets.
“The situation as I see it for that lower echelon for high yield is that a lot of these companies have had a unique opportunity to refinance their debt in this low rate environment. It caused their balance sheets to get stronger as a result,” said Lurie. “That being said, there is always a challenge for these lower rung companies that profitability might not necessarily return. You can’t necessarily make a holistic statement about companies that fall into that bucket.”
– Ben Eisen
Follow Ben on Twitter @beneisen
More from Behind the Storefront: