Looking Beneath the Surface: A Toys “R” Us Cautionary Tale

by:
Strategic Asset Allocation & Solutions Group, New York Life Investment Management

Toys “R” Us didn’t exactly close its doors, but the largest toy retailer in the world has filed for Chapter 11 – a form of bankruptcy that will allow it to restructure its debts. The timing is strange, given the strong global economy and lower unemployment that might lead to increasing demand for consumer discretionary products, like toys. And yet, Toys “R” Us owes its suppliers significant money that it can’t seem to re-pay.

This sort of bankruptcy in this environment serves to remind investors of two important issues. First, economic cross-currents are at play, even when the surface appears calm and stable. Second, the late stages of an economic cycle may call for heightened caution.

How Did This Happen?

Part of the problem in the case of Toys “R” Us is that it was late to the e-commerce game. In the nearly 10 years following the global financial crisis, online sales have doubled, while department stores’ sales have fallen more than 30% and retail sales have increased only 30% in totality (Figure 1). Missing the boat on facilitating toy distribution on the Internet may have been a very costly management oversight for this retailer. This only underscores the importance of corporate leadership that is agile and attuned to disruptive industry changes.

Figure 1: Online Retail Sales Significantly Outpace Other Sectors

U.S. Retail Sales – Growth of Sales by Sector

Sources: Thomson Reuters Datastream, New York Life lnvestments.

What Kinds of Businesses Are Winning?

There’s no doubt that timely and relevant business investment, which improves productivity and makes use of technology to scale its pipeline, is more important than ever. Companies are spending on software and technological infrastructure, and if this continues, it will most certainly add longevity to the current expansion (Figure 2). Those who don’t may risk falling behind the curve.

Figure 2: Business Investment Picks Up, Particularly in Technology

U.S. Business Capital Spending

Sources: Thomson Reuters Datastream, New York Life lnvestments.

What’s There to Be Careful About?

Toys “R” Us isn’t the first big retailer to face troubles, and it certainly won’t be the last. For now, default rates1 among companies are low. Credit spreads2, however, are perhaps even tighter than current defaults may justify (Figure 3).

Figure 3: Credit Spreads Are Low and Defaults Trend Downward

Sources: Thomson Reuters Datastream, New York Life lnvestments.

With credit spreads so tight, it may be prudent to look at other potential warning signs. On one hand, a recession in the U.S. looks distant, and our credit cycle indicators do not point to an immediate pickup in default rates (Figure 4). On the other hand, there are increasingly suspect credit conditions to keep an eye on. Anecdotal evidence of increases in bad credit card loans to individuals and new loans to businesses in the U.S. without periodic performance guidelines (also known as covenants) may signal a need for additional caution ahead.

Stability at the surface is only reflective of the economy to a point. Default rates can, and will, likely trend lower for some time, but rapid cross-currents are mixing below. Navigating those currents will surely require a flexible and active approach. Additionally, the current asymmetrical risk and reward profile3 in fixed income warrants a more cautious approach to credit. Investors may want to consider evaluating their credit exposure, and considering more defensive high yield strategies.

Figure 4: A Selection of Economic Indicators Suggests Defaults Should Remain Low

Source: Thomson Reuters Datastream, as of 9/30/2017. Institute for Supply Management PMI, Federal Reserve U.S. Credit Card Delinquency Rates, U.S. Federal Reserve, U.S. Household Financial Obligation Ratio, U.S. Corporate Profits. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

1. The percentage of borrowers who fail to remain current on their loans. It is a critical piece of information used by lenders to determine their risk exposure and by economists to evaluate the health of the overall economy.

2. A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality. It reflects the additional yield received for an additional unit of risk.

3.  An asymmetrical risk and reward profile represents an imbalance between the risk and the reward of an investment. In this case, we refer to a negative asymmetrical risk and reward profile where the potential reward is less than the potential loss.

Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

About Risk

All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.

Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets’ country of risk, based on the indices’ EM country definition, are excluded. The US Corporate High Yield Index is a component of the US Universal and Global High Yield Indices.

High-yield securities carry higher risks, and some of the Fund’s investments have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.

This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell or the solicitation of offers to buy any security. Opinions expressed herein are current opinions as of the date appearing in this material only.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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SAS Group

Strategic Asset Allocation & Solutions Group, New York Life Investment Management

NYLIM’s Strategic Asset Allocation & Solutions (SAS) Group invests tactically across the full span of global capital markets, designing comprehensive solutions for a variety of client needs. Managed assets include MainStay Asset Allocation and Retirement Funds, mandates for third parties, and a customized strategy for the New York Life General Account.

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