Martin Foden, Head of Credit Research at Royal London Asset Management considers the challenges of investing in the retail sector and how to be protected if things go wrong.
Everyone knows that traditional ‘high street’ retailers are struggling. Barely a week passes without another company going into receivership or announcing store closures: House of Fraser, Thomas Cook, New Look, Boots... even Poundworld couldn’t buck the trend (see figure 1).
And the headlines will keep rolling. Debenhams and Arcadia (whose brands include Burton, Dorothy Perkins, Miss Selfridge and Topshop) are trying to shore up their businesses. Even John Lewis, which appeared to defy gravity for years boosted by its ever-more heart-tugging Christmas ads, is retreating. It announced in March that staff would receive just a 3% bonus, the lowest since 1953, due to difficult trading conditions.
Figure 1: Closing down sale – net shop closures are accelerating as high streets struggle and retail habits change (source: LDC/Guardian).
The causes are myriad. Retail is inherently economically sensitive, but there are also more prosaic challenges, such as high business rates and distorting tax rates. These are interwoven with powerful secular dynamics, including increased online penetration and changing consumer behaviour.
Every little helps?
At a more specific level, memories do not have to be particularly elephantine to recall Tesco’s salutary journey. Stratospheric growth in store sizes, locations and product offering was heralded as a new paradigm in retail but, in truth, represented nothing more than the more temporary benefits of scale economies and macro tailwinds.
Throw in a dollop of management hubris and the more humdrum reality of excess capital invested and diminishing returns, and Tesco’s subsequent collapse was a clear example of the sector’s established trend for mean reversion. More recent signs of stabilisation, as newer management sweeps the decks and reverts to greater capital and balance sheet discipline, are further evidence of this sustaining truth.
All of which raises interesting questions for bond investors. How can we identify the retail survivors and, perhaps more relevant given the skewed risk of credit, how to protect our clients from the downside should retailers fail?
As creditors, recognising these challenges is probably the first step to mitigating them effectively, and this informs our research framework and portfolio construction. In short, where analytical foresight is limited and volatility is a given, we invest selectively and only within extremely diversified credit portfolios. And, perhaps most critically, when we do have conviction to lend our clients’ money to a retailer, we typically do so on a secured basis. By contrast, a significant majority of retail bonds in an index are unsecured, meaning any performance deterioration is often amplified.
Stores of value
For illustration, credit investors can get exposure to retail cash flows by buying specific asset backed bonds, for instance in the supermarket sector. Choose the right one and this can provide the additional safety valve of security over supermarket assets worth five times the value of the bond at yields not dissimilar to those on offer from unsecured, but potentially more visible, WM Morrison debt. Security and excess return? A ‘buy-one-get-one-free’ offer that really is too good to ignore.
Security is not a panacea, however, and lending in this way demands additional scrutiny and analysis, not least around the value and quality of the collateral provided and the legal protections (covenants) we have to maintain control and asset cover through our lending period.
Perhaps most pertinent when it comes to evaluating secured bonds is the correlation of asset values to the underlying performance of the retailer. Ultimately, if the value of charged property is inescapably linked to the health of the issuer’s cash flows, then the benefit of this credit enhancement is clearly compromised and, potentially, entirely illusory.
Consequently, when we purchase secured retail bonds, or even less direct exposures, such as bonds secured on shopping centres, we also consider the intrinsic value of the collateral, either on an alternative use or vacant possession basis.
For instance, we lend against Westfield Stratford – an asset with obvious value as a destination for consumers and a physical showcase for retailers, even when their business models are under attack from online consumption. Further factor in our senior claim and low issuer leverage and this is clearly a fundamentally different risk proposition to buying debt secured on secondary and tertiary shopping centres.
As long-term investors, with multi-cycle experience and a keen understanding of skewed credit risk, we are primed to recognise the inescapable volatility of certain sectors. We are equally sensitive to the potential for this risk to be under-priced at certain points through the cycle, either due to an issuer being perceived as the next retail ‘winner’ or simply because of the market’s predilection for name recognition.
While we may typically have lower sector exposure than bond indices, however, the existence of genuine and protective credit enhancements in certain retail and retail-related bonds and, crucially, clear inefficiencies in the market that allow us to buy these secured bonds at elevated spread levels, motivates us to find mispriced bond opportunities, even when the headlines may be less than compelling.
Issued by Royal London Asset Management
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For more information on the fund or the risks of investing, please refer to the fund factsheet, Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Price page on www.rlam.co.uk The views expressed are the author’s own and do not constitute investment advice. All information is correct at June 2019 unless otherwise stated.
Issued by Royal London Asset Management Limited, Firm Registration Number:141665, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, Firm Registration Number: 144037, registered in England and Wales number 2372439; RLUM Limited, Firm Registration Number:144032, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogerson’s Quay, Dublin 2, Ireland. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London EC3V 0RL. The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal London Mutual Insurance Society Limited is on the Financial Services Register, registration number 117672. Registered in England and Wales number 99064. Ref: AL RLAM PD 0023