Corporate Credit

 

Hoverboards and Michael Jordan shoes. I can’t get through a conversation with my kids without one or both of these topics coming up. I have to admit, being a huge Back to the Future fan and growing up in Chicago during the Bull’s domination of the 90’s, I am excited about this holiday season. This is always a very important time of year for the retailers, as up to 40% of annual revenues are realized during this season. Based on our figures from the U.S. Census Bureau (retail, excluding auto and gas), retail sales for 2014 were up 4.4%. We believe that retail sales for this year will be up between 3.25% and 3.75%. The following report explores some of the more important drivers of our analysis.

---

 

The Consumer is Strong

We believe the most important driver of retail sales is the strength of the consumer. The following table summarizes our analysis of nine different factors which drive the willingness to spend. We make an assessment of the individual factors in terms of how we think they may impact future spending.

The overall picture is about the same as last year.  Positive developments include falling gas prices and stronger consumer confidence data.  Home prices and sales look steady and we continue to see more spending on home improvement.  Homeowners spend more aggressively when their homes transition to an investment from a cost.  Stagnant income growth coupled with rising personal debt could impact spending. Currently, credit card performance has been solid, so we would not expect rising credit card balances to slow spending.  In addition, GDP in the U.S. remains volatile throughout the year with expectations to flat line through 2017, signifying a pretty benign economic environment.

Big Ticket Item Spend Could Slow Holiday Shopping

Once again, a significant amount of consumer spending this year has been on big ticket items, including new cars and home appliances.  The fear is that spending on these sorts of items could impact holiday season shopping for various discretionary items.  Auto sales continue to consistently come in higher than expected with the last two months above a SAAR (Seasonally Adjusted Annual Rate) of 18 million, which hasn’t happened in more than 10 years.  Most analysts point to easy access of funding and attractive incentives to explain this sort of growth.  In addition, there are also secular trends driving demand including the increasing age of used cars and number of cars owned per household.  Years of pent up demand from curtailed spending, high average appliance age (approximately 10 years), an improved housing picture, and a better job environment are giving consumers greater confidence to spend on their homes.  We continue to see strong buying in the large appliance sector.

We took a closer look at the history of auto sales and potential impact on consumer spending.  To do this, we used information from the monthly retail trade data completed by the U.S. Census Bureau.  We segmented the Motor Vehicle & Parts Dealers portion of spending and compared it to retail spending (Exhibit 2).  What we observe is that retail spending (not including autos) is growing faster than auto spending.  The green line is the ratio of auto versus retail spending. That ratio has been growing and is currently at 36%, well below the maximum of 48%.  Based on this information, it appears there is still opportunity for auto sales to grow without impacting retail spending.

Big ticket items include technology as well.  This year, there are a number of new/innovative electronic devices available for the holiday.  These include the iPhone 6s, 4K Ultra TV’s, drones, fitness trackers, 3D printers, and connected home technology.  The Consumer Electronics Association expects tech spending this holiday to be up 2.3% to $34.2 billion.

Statistical Analysis – Predicting a Slow Down

Looking back on data over the last twenty two years reveals a significant correlation (81%) between “Back to School” retail sales (August and September) and “Holiday” sales (November and December). To complete this analysis, we used the U.S. Census Bureau’s monthly retail trade data, which includes a variety of retail businesses.  We exclude Motor Vehicle & Parts Dealers and Gasoline Stations from our analysis because sales in those segments have been more heavily impacted by factors outside the control of consumers.  In 2014, “Back to School” sales of 4.0% led to “Holiday” sales of 4.4%.  Our model predicts “Holiday” sales of 3.2% when using 3.0% for the “Back to School” sales observed in 2015. Holiday sales of 3.2% would be below the 23 year average of 4.2%.

Seasonal Hiring Looks Similar to Last Year

The National Retail Federation predicts that between 700,000 and 750,000 seasonal workers will be hired this year[note]Retail Employment and Seasonal Hiring. ”National Retail Federation, derived from Bureau of Labor data.https://nrf.com/resources/holiday-headquarters/retail-employment-and-seasonal-hiring, accessed November 17, 2015.[/note]. This compares to 714,000 hired last year and 765,000 hired in 2013.  Companies, including Macy’s, Kohl’s, and Walmart seem to be adding holiday staff in a somewhat conservative manner.  We continue to see hiring shifts to distribution warehouses which support online shopping.  E-commerce giant, Amazon is hiring 100,000 seasonal employees which is up significantly from 80,000 last year.  In addition, shipping giants FedEx and UPS are predicting a similar holiday season to 2014.  UPS expects to ship 10% more packages between Thanksgiving and New Year’s (3Q Earnings Transcript).  UPS expects their peak day to be December 22, when they expect to ship about 36 million packages, twice the normal amount in a day (3Q Earnings Transcript).

Higher Inventory Should Lead to Better Discounts

Technology working closely with demographic and social change has altered the way traditional retailers are selling/marketing their products.  One of the outcomes has been a much more efficient and better informed shopper.  Shoppers will continue to deal hunt, forcing retailers to sharpen their prices and start promoting earlier.  This year, we believe that retailers are in a less favorable inventory position versus last year.  We took a look at the inventory-to-sales spread (inventory – sales growth (year/year)) for a variety of retailers since 2013.  In a perfect world, we would want to see this at zero as inventory build keeps the same pace as sales.

A positive figure might result in price discounting by retailers, as they are stuck with too much inventory.  As shown in Exhibit 3, the average inventory-to-sales spread seems to have picked up somewhat since the second quarter of 2015.   While it is too early to determine the pace in the third quarter, so far, it looks as if inventories are up substantially, as sales have been disappointing.  Lower tourism and luxury spending seem to be a building theme in the locations that are geared toward higher income spenders.  The problem can be partly blamed on weaker emerging stock markets and a stronger U.S. dollar versus other currencies.

As a result, we expect retailers will need to be aggressive with discounts this season.  We expect retail margins to be somewhat stable as costs, especially commodities, have generally decreased.

Online Shopping Blazes Ahead – Department Stores Have a Big Opportunity

A solid e-commerce strategy has become a “must have” for all major retailers.  Even with the incredible advancements in this area, most shoppers still want to visit an actual store.  Retailers must continue to update their stores to remain relevant amongst a huge host of competition.  Omni-channel retailing has merged the inventory and distribution of physical stores with the online business.  In short, it has simplified and enhanced the entire buying process. According to the U.S. Census Bureau, e-commerce now accounts for 7.2% of total retail sales.  Year over year growth since 2010 has averaged 15% on a quarterly basis.  According to the National Retail Federation, the average shopper said that 46% of their shopping will be completed online[note]Retail Employment and Seasonal Hiring.”National Retail Federation, derived from Bureau of Labor data.https://nrf.com/resources/holiday-headquarters/retail-employment-and-seasonal-hiring, accessed November 17, 2015.[/note].  In addition, mobile devices are now much easier to use and play a bigger role in shopping for consumers.  One important outcome of e-commerce has been quicker delivery.  The much talked about Millennials are helping shape the evolution of retail.  It’s interesting to note that about 16% of this group expects to use the “same day delivery” option this holiday compared to just fewer than 8% for the rest of the population.

One area of particular interest is in the department store segment of retail.  This has been especially newsworthy given the very high profile e-commerce push at Walmart.  E-commerce is a big opportunity for large department store retailers given lower online penetration and slower same-store-sales growth at brick and mortar stores.  Exhibit 4 gives a good sense of the upside when compared to other retail segments.   One example of the growth opportunity is in the consumer electronics segment which doubled its online penetration to almost 24% in only four years[note]Steven Grambling, CFA, Alison Levens, Chistopher Prykull, CFA,. “Bricks and Click reboot: Adoption accelerates, margin trajectory grows murkier,” Goldman Sachs Equity Research – Americas: Retail: Broadlines, October 22, 2015 (6).[/note].

In general, we would expect margins to compress as a larger percentage of the business is moved online.  Also, capex spending would shift more towards e-commerce spending and less to net new builds.

Trade Group Surveys Expect Lower Growth in 2015

We have included a summary of the four trade groups which publish their views on upcoming holiday sales (Exhibit 5). While each of them uses a different data set to base their expectations, the more important aspect is the change in growth year–over-year. In addition, we thought it would be interesting to look at how accurate each group has been over the past three years. The International Council of Shopping Centers (ICSC) seems to be the most accurate.

Weather and Calendar Remain Relevant

Weather and the changing calendar are always important factors for holiday spending.  Last year, November was colder and December was warmer than normal.  We saw a lot of snow in November and a very limited amount in December.  According to Weather Trends International (WTI), this holiday season is expected to be milder with temperatures warmer and precipitation lower than normal[note]Denise Chai, CFA, Lorraine Hutchinson, CFA, Robert F. Ohmes, CFA, “Holiday ’15: Santa’s sleigh faces uphill ride,” Bank of America Merrill Lynch, Equity. Oct. 21 2015, 7.[/note].  Of course, better weather makes travel easier for consumers.  Having said that, consumers are less likely to buy winter focused products when the weather is unseasonably warm.  A more severe winter might actually be a good thing especially given the growing popularity of online shopping.

The days between Thanksgiving and Christmas are key shopping days.  This year, those days total 28 (26 is the minimum, 32 is the maximum) versus 27 last year.  In addition, there are eight total weekend days to shop, the same as last year.  One more day will probably not make a significant difference.  We would not expect this to be a factor in our estimate for 2015 sales.

Conclusion  

We believe 2015 will be a decent year for holiday spending coming in slightly below last year’s growth.  Overall, the typical consumer is in a better economic position than recent years.  We believe mediocre job growth and inflation adjusted wages will limit the upside to spending.  We would expect retailers to be challenged somewhat with higher inventory positions this year, especially if tourism related spending does not return to normal levels.  In addition, we believe consumers will continue to purchase big ticket items, which may negatively affect other areas of consumer spending.  Seasonal hiring outlooks and subdued predictions from various trade group organizations support our prediction of a slower holiday season in 2015.  The calendar will look very similar to last year while the weather is expected to be harsh but not quite as bad as last year.

Michael Ashley
Principal and Senior Analyst, Corporate Credit

---

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

---

 

• Liquidity in the bond market is substantially reduced.
• This liquidity reduction is structural, driven by regulation and a reduced field of intermediaries.
• At the same time, institutional fixed income management has consolidated in order to capture benefits of scale, but their ability to transact is reduced.
• In this environment, there is benefit to being a nimble manager.

---

Dimensioning the Bond Market and Liquidity

Since the extreme disruption of the global financial crisis in 2008 the world and the U.S. have experienced a deep economic recession followed by a much slower than expected resumption of GDP growth (Exhibits 1 and 2).

 

The response of central banks and policy makers to the economic downturn and the subsequent slow recovery have been broad and aggressive, including both conventional policy such as interest rate cuts and non-conventional approaches including aggressive quantitative easing in the large developed markets (Exhibits 3 and 4).

 

The sustained low rate environment, as well as the introduction of quantitative easing via open market purchase programs, has resulted in an acceleration of the growth of global leverage even as the mix has shifted (Exhibit 5).

U.S. dollar denominated fixed income markets have participated in this expansion of leverage with the overall market experiencing 18% growth since 2008.  While the most rapid rate of growth has been in government linked indebtedness (116%), it has been followed by corporate indebtedness (45%) as shown in Exhibits 6, 7, and 8.

 

 

And in particular, growth of the corporate bond market has been propelled both by a move away from bank loans and an influx of retail money in the form of mutual funds and Exchange Traded Funds (ETFs) as well as non-U.S. investors (Exhibit 9).

At the same time that the corporate bond market has experienced record growth, liquidity within the asset class has been dramatically reduced.  The most obvious sign of illiquidity is the materially reduced inventories held by the global banks that act as the main intermediaries in the market (Exhibit 10).

While reduced dealer inventories in all classes of fixed income are evident, the fall in inventories relative to the growth in the size of the corporate bond markets is particularly striking (Exhibit 11).

Further evidence of reduced liquidity can be seen in the static daily turnover and average trade size in the corporate bond market (despite the 45% growth in the outstanding).

 

Why Has Liquidity Been Reduced?

The cause of the reduced liquidity is twofold.  Firstly, the advent of new banking regulations in response to the global financial crisis has increased the capital intensity of bank owned capital markets businesses, incentivizing balance sheet reductions by this group of intermediaries.  Secondly, the global financial crisis has reduced the traditional pool of intermediaries (the “sell side”), either through outright failure, or through a retreat from the capital markets business.

The main regulatory developments impacting bond market liquidity have been the advent of the Basel III capital guidelines and the Dodd-Frank Act.  The Basel III guidelines are a recommended framework for bank capitalization which were finalized in 2011 in response to shortcomings of the previous capital guidelines that were exposed by the global financial crisis (most notably undercapitalizing against the risks inherent in capital markets businesses and securities inventories).  The Dodd-Frank Act signed into law in 2010 represents the U.S. Congress’ attempt to remedy the shortcomings in regulatory oversight of the U.S. financial sector that came to light during the financial crisis (and which set the stage for the U.S. adoption of the Basel III guidelines).  The key aspects of the Dodd-Frank Act that have impacted liquidity of the U.S. bond market include:

1. Implementation of Basel III capital rules – while the new capital guidelines materially increased the minimum levels of capital, they also raised the risk weighting assigned to securities portfolios and counterparty exposures resulting from OTC derivative trades.  The increased capital requirements and risk weightings have made the fixed income business considerably more capital intensive (Exhibit 14).

   

2. Imposition of a leverage ratio – in addition to increased risk weighting of securities on the balance sheet, Basel III has imposed a leverage ratio that measures capital against gross assets.  This measure of capitalization is meant to protect against any gaming of risk weightings, and particularly penalizes inflated balance sheets (even those consisting of low risk weighted assets such as secured repo and highly liquid Treasury and agency debenture portfolios).  The impact of the leverage ratio can be directly observed in the reduction of money center trading portfolios (Exhibit 15).

   

3. Volker Rule – the Volker Rule was a late addition to the Dodd-Frank Act and was meant to cap “risky” activities previously undertaken by banks.  Most relevant to the discussion on corporate bond liquidity is the prohibition on “proprietary” trading, defined as trading that is not reasonably associated with customer-based activity.  While the implementation of this part of the Volker Rule has been somewhat watered down, it remains subject to regulatory discretion and it has been cited as a driver of reduced trading inventories and staff by bank management.

While increased regulations have reduced the depth of bond market liquidity, the global financial crisis also caused a reduction in the breadth of market liquidity as intermediaries either failed or retreated from the market.  The failure of Bear Stearns and Lehman Brothers, as well as the sale of Merrill Lynch to Bank of America represented the most obvious removal or consolidation of market makers.  Numerous European banks have also been forced by their domestic regulators to pare back their capital markets businesses.  Institutions such as UBS AG, Credit Suisse, Royal Bank of Scotland and Barclays Capital, which had previously been heavily involved in the U.S. fixed income markets, have downsized their capital markets staffing and market making.  While various pools of capital have attempted to replace these traditional intermediaries, the effect of new entrants has been muted.  Non-bank intermediaries such as hedge funds and start-up broker/dealers have had uneven results and have been reluctant to commit meaningful capital to market making.  At the same time, several alternative bond trading platforms have failed to gain a toehold in the markets (with the liquidation of the online start-up Bondcube being the latest failure).

Shift in the Bond Buyer Universe

At the same time that bond market liquidity has been challenged by increased regulations and a narrowed field of intermediaries, the bond buyer universe has experienced a transformation.  Insurance companies and pensions have remained large buyers, but their proportion of the market has dropped.   In contrast, mutual funds/ETFs and foreign buyers have increased as a proportion of the buyer base as investors have attempted to offset the impact of low rates by extending from money market funds (Exhibit 16).

The investment management field has experienced rapid consolidation as bond buyers strive to gain economies of scale.  Over the past decade, the twenty largest institutional fixed income managers have increased to 60% of total fixed income assets under management vs. 50% a decade ago, even as the overall market size has grown.

Importantly, the mutual fund and ETF component of these asset managers’ AUM have grown as investors that previously would have invested in money market or treasuries instead pursue income through broad fixed income exposure (Exhibit 17).

 

Implications for Investors

Corporate bonds as an asset class have largely been a one way trade since 2008, with spreads tightening even as supply has exploded.  Reduced liquidity has ramifications for investment management clients both in the current environment, and when the credit cycle turns.

Going forward, total return opportunities in fixed income will increasingly be generated from yield as opposed to opportunistic trading.  While increased scale benefits the largest managers in the new issue allocation process, their absolute size is making it increasingly difficult to build meaningful positions across portfolios.  Stealth indexing becomes a risk if managers are forced to buy every new deal that comes to market just to maintain diversity and exposure.

Because of the lack of secondary market liquidity, large managers also face limits on their ability to add to positions outside of the new issue market.  And liquidity challenges will be aggravated in more volatile markets, making outsized positions difficult to liquidate in more volatile markets.  In this context, portfolio construction becomes an enterprise risk management consideration.  Bond maturities and cash flow profiles of fixed income portfolios will be critical to meeting client liquidity needs.

In this environment, investment performance will accrue to the providers of liquidity from forced sellers.  It will be critical to position client fixed income and surplus strategies to be liquidity providers when there are forced sellers and traditional intermediaries pull back from the market.

Against this backdrop, the benefits of hiring a nimble manager become readily apparent.  Defined as being able to execute a chosen investment strategy in the current and foreseeable markets, nimble managers necessarily:

• Can implement portfolio positioning through trades roughly at the market average trade size
• Are able to achieve duration targets in individual credits without owning every outstanding issue
• Do not need to own every issuer that comes to market  in order to achieve credit diversification
• Can reduce or eliminate credit exposures without causing market dislocations

It is important to make the distinction between managers that are merely small and those that are nimble, with the latter maintaining institutional level market access and an investment team that is able to independently identify and recommend investments on a timely basis.

Specific Example:

With 90% of total corporate bond trade volume in lot sizes below $5 million, the ability to build material positions outside of the new issue market is minimized.  As an example, a manager with $100 billion in assets under management (AUM) trying to grow an exposure to a single credit from 10 basis points to 20 basis points of the portfolio would likely need to execute close to 50 separate trades (Exhibit 19).

Even more concerning is the prospect of increasing volatility of both flows and spreads when market sentiment turns.  Returning to our hypothetical $100 billion AUM manager, we assume a 20% weighting to corporate bonds ($20 billion).  A decision to reduce corporate bond exposure to 17% necessitates the sale of $3 billion of bonds.  Within the context of the average trade size of less than $5 million, this would entail in excess of 500 trades.  Even assuming that a larger manager was able to engage in block trades for a portion of the portfolio reduction, a $3 billion portfolio reduction represents 15% of total primary dealer inventory, so it is reasonable to expect that such a repositioning would impact prices and likely require a sustained period of time in order to execute.  If such a repositioning were occurring against the backdrop of a negative shift in market sentiment and a pull back by intermediaries, the ability of larger managers to execute portfolio shifts would be further constrained.

Considerations Going Forward

Have regulatory efforts to decrease systemic risk in the banking system increased systemic risk in the capital markets?

To be determined; while lower liquidity/increased volatility appear to be the unintended consequence of the regulatory response to the global financial crisis, higher capitalization and lower systemic leverage (in the financial system anyway) mean that the financial system is better able to sustain the same.

How will fixed income investors react to an eventual removal of easy monetary policy by central banks?

While a sustained rising rate environment would benefit insurance investment clients, the reaction of the new entrants (foreign investors/retail mutual funds/ETFs) in the face of falling prices is less certain.  Although mutual funds and ETFs promise continual liquidity to investors, this has yet to be tested in a sustained rising rate environment, particularly for illiquid underlying investments such as corporate or municipal bonds.

Should fixed income investors pay active management fees for passive management results?

We previously touched on the potential for “stealth indexing” to occur when large managers are forced to buy new issues indiscriminately just to stay diversified. Clients should pay careful attention to their investment managers’ ability to customize portfolios and execute their investment ideas efficiently, while also generating needed liquidity, achieving target returns, and prudently managing risk.

N. Sebastian Bacchus, CFA
Senior Analyst, Corporate Credit

---

 

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees.  This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.