Dollar General and Neiman Marcus are both retailers, but other than that they don’t have a lot in common. Except one thing… they’re both growing.
Interestingly, they serve opposite ends of the retail spectrum, which is good for them because growth is not uniform across the retail landscape. The mushy middle is declining and it’s taking a toll on the likes of J.C. Penney, Sears, and RadioShack.
These middle-income retail companies are all having financial difficulties and should be running scared as they look for ways to borrow money while they attempt to turn around their contracting sales.
But a funny thing happened on the way to the bond markets… these retailers found a ton of willing lenders.
In fact, these companies have been able to secure billions of dollars in financing.
That’s because monetary life support has become a two-way street. While retailers are struggling to survive, so are fixed income investors.
Rates have been so low for so long that people can hardly remember a time when high yield meant returns above 8%, much less 10%. Gone are the days when high-quality bonds threw off a yield of 7% to 8%. Nowadays, investors are lucky to get 4% on high quality investments and 6% on junk bonds… 6%! Keep in mind that in 2007, CDs were yielding 5%.
As the saying goes: “Something’s gotta give.” And that “something” is quality.
If you’re a bond buyer who relies on the income from bonds to provide for your daily living, the last few years have been brutal. When the Fed came to the rescue after the economy broke down in 2008 and 2009, yields fell like a rock.
This meant that existing bonds shot up in value… but that only mattered if you sold them. Otherwise, the yield was already set. Any bonds that investors have bought since interest rates plunged have been at much lower yields.
So as investors have had to replace bonds that have been called away, or simply add bonds to their portfolio, they’ve had to make a compromise. Will they give up income and keep buying the same quality of bonds at lower interest rates? Or will they give up quality and buy riskier bonds that have relatively higher yields?
For many, it’s no choice at all. They need the money, so they buy the riskier bonds. This means that investors are putting themselves at greater risk of loss of capital for a couple more percentage points of interest. It’s not a problem… as long as the borrowers make good on the money.
J.C. Penney lost $1 billion in the last year. RadioShack is operating at a loss as well. Sears is limping along with disappointing sales and is selling Lands’ End. The main driver of their sales — the middle income tier — is shrinking. Unless this turns around soon, it’s entirely possible that retailers like these will disappear, leaving behind not only empty stores, but also bondholders with empty pockets.
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Ahead of the Curve
It may well be true that struggling corporations are being lulled into a cheap money trap — taking advantage of Fed-manipulated rates to acquire cash, when what they really need to acquire is more customers. And if the borrowed money runs out before the companies can turn it into revenue and profit growth, bond investors will certainly get the short end of the stick.