Short-sellers are placing heavy bets against malls and other retail properties, but the trade risks going very badly as long as the troubled sector’s bonds keep holding up well.
Investors have been pouring money into credit default swaps based on the CMBX 6 index, which is made up of a basket of 25 reference commercial mortgage bond deals.
The bet is that those bonds, which are seen as a proxy for the broader retail sector, will incur defaults in the underlying loans.
But as long as that does not happen, the investor must keep paying a monthly premium - a potentially expensive proposition, as the index’s bonds continue to hold steady.
“It’s hard to know which malls will survive and which won’t,” Teresa Walters, a portfolio manager at Amundi Smith Breeden, told IFR.
“But there are monthly coupon payments that still need to be paid to keep protection in force.”
CLOSING DOWN
In theory, commercial mortgage bonds underpinned by loans to dying malls should be riddled with defaults that would thus deliver handsome returns for the short-sellers.
Nearly every day sees another longtime US consumer icon - from Sears to Payless to Ralph Lauren - coming to market with news that runs from bad to worse.
But in practice, the index is still only based on 25 particular bond deals - and if their underlying loans are not distressed, the problems elsewhere make little difference.
“It is expensive to short CMBX to express a negative view on retail,” said Tracy Chen, head of structured credit at asset manager Brandywine Global.
“To make the trade work, the timing of the underlying default has to be accurate, which is quite difficult to achieve.”
JC Penney, for example, announced in late February that it would close about 14% of its stores - news that sent spreads on Triple B bonds in the index dramatically wider.
But when the struggling retailer finally announced which 138 stores would be shuttered, according to Moody’s Investors Service, only one of them was even linked to a bond deal from 2012 - the vintage that makes up the whole CMBX 6 index.
“Shorting malls is becoming less compelling,” an analyst report from Citigroup said this week. “Mall closures are a second-order effect of retail downside.”
PILING IN
Despite the risks, hedge funds and others betting against retail have been aggressively buying up CDS contracts that short bonds in the index.
The amount of CDS contracts on BBB rated bonds in the index more than doubled from January 2016 to March 2017 to US$8.66bn, according to the Depository Trust & Clearing Corporation.
That sort of crowding in the trade has raised more than a few eyebrows in the market.
“This whole thing is really taking on a life of its own,” said one CMBS analyst who asked not to be named.
“Retail is in a jam. But it’s kind of like a game of Telephone. It’s all predicated on ideas instead of facts.”
And the index was not intended to provide market players with a way to gamble on the direction of the retail sector.
It was created in 2012, in the aftermath of the financial crisis, mainly as a way to help banks hedge their exposure to new commercial mortgage loans.
But those loans were made to a variety of commercial real estate projects, with only 35% of the loans in the CMBX 6 index made to malls and other retailers.
And at the time the index was created, those projects were thought to be some of the safest in the commercial real estate market, especially as standards were conservative just after the crash.
“Deals referenced by the Series 6 generally were considered the safest and least levered risk issued since the credit crisis in CMBS,” said Western Asset Management portfolio manager Harris Trifon.
For those reasons among others, many market participants say taking out swaps on the index is not as good a wager as simply betting on individual retailers.
“Investors have been trying to position for an overall decline in the retail sector,” the Citigroup report said.
“Buying protection on a basket of retail CDS names makes more sense.”
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