Here’s How To Play The Retail “Big Short” (Hint: It’s Not CMBX)

Regular readers have been kind enough to let us regale them with the unfolding drama that is the bursting of America’s $1.2 trillion auto bubble. We call it Car-mageddon.

Of course anyone who’s been paying attention over the past six or so months is also acutely aware that there’s another sector of the US economy imploding: retail.

We’ve discussed this on numerous occasions – especially with regard to HY. Recall for instance, the following chart which says a whole lot about the state of the market:

(Deutsche Bank)

Retail’s troubles are well documented. The rise of online competition and a steady decline in foot traffic and earnings seem to presage a veritable apocalypse for brick and mortar. And no, that’s not hyperbole. This is an existential crisis.

For obvious reasons, the trade du jour on this has been shorting CMBX with mall exposure. Specifically, the CMBX.6 BBB- tranche. Or, visually:

(Citi)

But according to at least one bank, that trade may have already run its course. [CMBX is so last month]. Those looking for downside exposure from here may want to express a bearish view more directly. That is, by simply buying protection on retail CDS. Here’s more…

Via Citi

First, mall closures are a second order effect of retail downside. While it is true that we have seen some of the major retailers announce large numbers of store closures recently, it is by no means clear that all of these closures will lead to mall bankruptcies or closures. Indeed, at the recent Citi Property Conference, retail REIT CEOs highlighted on-going efforts to re-tenant mall space that is going vacant as a result of departing retail names. In some cases, malls are also attracting grocers to fill the space vacated by department stores.

Second, even if it were the case that stress in the retail sector produces significant downside for associated malls, we argue that the short CMBX trade may not have much downside left.

We therefore believe that a more appropriate way to express a short view on the retail sector is to go directly to the source, i.e., look to retail CDS. This has several advantages over other forms of shorting retail. First, any deterioration in the sector will be directly reflected in the credit quality of the retail names. In addition external factors such as efforts to re-tenant malls are unlikely to have much effect on retail CDS. Second, from a cost perspective, the unfunded nature of retail CDS makes it easier to finance and hold a short position compared to shorting retail stocks because of the difficulty in sourcing and associated borrow costs. Finally, it is difficult to assign a timeline around when the retail sector begins to capitulate and defaults start to occur. Given that, we are more comfortable using the CDS market where maturities are longer (even go up to 10 years) versus the option market, where maturities are much shorter, and positions can also be subject to strike risk.