Fixed Income - April 2018

The Big picture

1) Treasuries Slide

Yields on the 10-year US treasury, the standard value for the risk-free rate, broke through the three percent mark in late April for the first time in 4 years causing float prices to fall. Yields rose across the curve except for the 1 Month notes which fell 2 basis points from 1.7% to 1.68%

Much of this was driven by the Fed’s diminished concern on the lack of inflation stated in the beginning of the month from March’s meeting. For the past several months inflation has remained stagnant despite a thriving economy which has puzzled many.

Some attribute this lack of price inflation to stronger price discovery created by ecommerce. As this has broken recently and inflation has edged back up to 2% the possibility of rate rises in the future have increased. This rise was probably unhindered, if not exacerbated, by the continuing decrease in unemployment which is now at an 18-year low.

2) Interest rates stay put...for now

On May 2, the Federal Open Market Committee held its third of eight meetings for the year 2018. This marked the second gathering with newly nominated Jerome Powell leading the charge as chairman. The Committee ruled in favor of maintaining the current federal funds rate range at 1.5-1.75% but noted strong signs of rising inflation, including the personal consumption expenditure price index indicating levels of 2%, right where the Fed wants inflation in the long-term.

It remains relatively clear that despite this hold, more rate hikes are to come as tax reform coupled with low levels of unemployment will continue accelerating economic growth within.

Snippets

1) Lampert’s Plans to Sell Core Assets Help Sears’ Bonds

Over the past month, Sears’ outstanding bonds that come due this October have skyrocketed in value after Eddie Lampert, chairman and CEO of Sears Holdings Corporation, discussed the possibility of his hedge fund, ESL Investments, buying certain assets from the business.

Lampert, who formed the retail conglomerate by merging Sears and Kmart, is particularly interested in divesting (and subsequently acquiring) the real estate of unprofitable and already vacant stores and the Kenmore brand.

This has sent Sears Holdings bonds from 70 cents on the dollar at the beginning of the month to 84 cents on the dollar, an increase of 20% driven largely by speculation that the assets will be sold at a premium compared to normal market conditions. While investors may be excited by this potential liquidity, Sears’ health remains in poor shape. The retail business continues to bleed cash, taking huge operating losses by not being able to cover its overhead expenses. Sears has faced lower sales volumes thanks to its inability to compete with e-commerce giant Amazon.com and other big-box retailers like Walmart which has forced the company to shutter hundreds of stores across the country in the past five years.

What is worse is that within one year, the company has roughly $3 billion worth of obligations due, including store leases, pension funding, and debt repayment with a cash position of only one-tenth of that value.

If the asset sales to ESL go through, there may be a chance to cover most of these obligations, but it will only be a matter of time before Sears completely runs out of assets to divest. With a retail business taking huge losses, divesting these limited assets may be the only internal source of cash flow the company can generate.

More long-term, Sears will still have roughly $2.3 billion worth of leases to worry about. In the current state of brick-and-mortar retail, it may become increasingly more difficult to find buyers willing to assume these obligations.

Mall foot traffic has been in a moderate decline for years and anchor store vacancies continue to rise, showing weak demand for the real estate Sears rents. As well, General Growth Property’s recent announcement of a sale (still subject to shareholder approval) of its entire business at a sharp discount to net asset value shows a weakening confidence in shopping malls across the country. With these factors to consider, the future of this once iconic American company looks unpromising.