Following an impressive performance in 2017, investment grade (IG) corporate bond spreads have decreased to near pre-crisis lows.
Many who attended grade school in the 1980s will remember the rise of the Trapper Keeper. These binders, often brightly colored and littered with stickers, doubled as fashion statements and were a focal point in retail stores as students wandered the aisles to examine the features of each one.
Of course, the back-to-school shopping experience has changed since then just as much as the merchandise, with new, technology-driven supplies increasingly bought online in a few clicks of the mouse rather than in a physical “brick-and-mortar” retail store. The growth of e-commerce sales is one of the biggest challenges facing apparel/textile/home improvement retail credits. Brick-and-mortar stores typically have higher fixed and variable costs, but consumers are cutting their spending in stores versus online. This shift to e-commerce is taking place even while store counts are rising (Figure 1), creating a significant supply/demand imbalance for many retailers. Investment grade (IG) retail sector credits have underperformed the Bloomberg Barclays U.S. Corporate IG Index in recent years partly due to these disruptive trends which have negatively impacted topline growth at major retailers (Figure 2).
We recognize these trends and are cautiously monitoring the Retail sector due to challenges presented by e-commerce, data privacy and store oversaturation. However, we recognize that the Retail sector has some positive trends that should be considered in credit evaluation and may provide opportunities in certain issuers.
First, we take into account that baby boomers are aging into retirement and millennials are graduating into the workforce – both trends that could transition large segments of the population from savers to spenders. In addition, as discussed in our recent newsletter article, The Millennial Investor, millennials are significant recipients of intergenerational wealth—although millennials have been shown to spend more on experiences rather than goods.1
Additionally, e-commerce is still less than 10 percent of the overall retail sales pie.2 While this percentage may grow as millennials spend more, brick-and-mortar stores remain the overwhelming drivers of retail sales in the U.S. Amazon.com Inc. remains a primary threat in the e-commerce battle; however, Amazon Prime membership trends also suggest a maturing user base at the company. More than 70 percent of U.S. households earning more than $112,000 have already purchased a membership to Amazon Prime,3 prompting the company to announce a 50 percent discount for membership applicable to people on government assistance. Companies like Walmart Stores Inc. (now integrated with Jet.com Inc.) have strategically chosen not to do a membership program, to retain online customers who do not want to pay a membership fee.
Finally, some stores – such as those focusing on home improvement – are more resilient to the trend of e-commerce. Large or bulky items lend themselves to physical store channels and aren’t as easily sold online. Home improvement stores have been able to afford to keep stores open because of the positive trends in the U.S. home market.4
Retail companies have implemented several changes to combat the growth of e-commerce. Some retailers are opting to purchase online operators rather than build the expertise and technology organically. For example, Wal-Mart Stores Inc. announced its purchase of Jet in August 2016 to gain a more robust online presence and to integrate the expertise of Jet’s managerial talent.
Some retailers are turning “back to basics” and investing in physical stores. Target Corp. is remodeling 600 stores and investing in systems, training and labor hours for its in-store employees. Target is also one of many stores focusing on technology to customize the ads and in-store experiences of shoppers to grow the top-line. Other stores are doing just the opposite and reducing retail store costs by closing stores. Department stores such as Macy’s Inc., Sears Holdings Corp. and J.C. Penney Company Inc. have announced significant store closures this year.
In our view, highly-rated IG retail credits are stable given slow and steady economic growth in the U.S. and still-healthy U.S. consumer spending. That said, given that e-commerce remains a small percentage of total retail sales, we believe the retail companies that perform best will be those that are able to manage this pervasive shift in channel preferences. This could include stores that:
- Embrace an omnichannel presence and cater to online customers through online marketing, shipping capabilities and other customer accommodations. For example, companies such as Target and Wal-Mart Stores Inc. are investing in the “buy online, pick up in store” option that brings on-line shoppers into physical stores.
- Manage broader declines in malls and anchor department stores.
- Adequately address the data privacy and security issues that could arise from growth in online sales.
- Determine the right balance of spending on e-commerce capabilities, costs related to layoffs and/or improvement in existing store footprints.
Breckinridge continues to perform rigorous bottom-up credit and environmental, social and governance (ESG) research, and we invest in companies that meet our strict credit standards. Our research helps us to identify risks and opportunities in the IG Retail sector given the current backdrop.
 Harris Poll. (2014). “Millennials: Fueling the Experience Economy.”
 Federal Reserve Economic Data, as of April 2017.
 Amazon Prime Penetration by Income, Piper Jaffrey, as of October 2016.
 Market spending on improvements, maintenance and repairs – including outlays by both homeowners and rental property owners—reached a record high of $340 billion in 2015 and continued to climb in 2016, up an estimated 6 percent to $361 billion. Source: Harvard University’s Joint Center for Housing Studies, Demographic Change and the Remodeling Outlook, as of 2017.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.