The Smart Money: Sears Holdings Corp (SHLD) Is Already Insolvent

Usually when a stock dishes out huge plunge over the course of one trading day, there’s an obvious, clear-cut reason explained in detail by the media. Not so with Sears Holdings Corp (NASDAQ:SHLD). Although SHLD stock fell a whopping 13% on Tuesday, most traders are still scrambling to figure out why.

The Smart Money: Sears Holdings Corp (SHLD) Is Already Insolvent

And yes, there was a reason. It wasn’t just one of those weird flukes where everyone simply decided at the same to shed Sears stock.

It’s just that the reason was one of those obscured ones that not even all of the so-called “smart money” would have been looking for.

Here’s the deal.

A Bet That Sears Can’t Pay Its Bills

To be clear, there’s never an iron-clad cause-and-effect relationship when it comes to what makes a stock tick. In this particular case, though, until a better explanation surfaces, the most plausible reason SHLD stock tanked on Tuesday was the sudden spike in the cost of insuring Sears’ bonds.

They’re called credit default swaps, or CDSes, which is a term that should ring a bell — credit default swaps were a key cause of the 2007-08 economic implosion.

A credit default swap is essentially a side bet on the true health of a fixed-income instrument. The buyer of a CDS fears the risk of default is a bit too high, as the contract calls for the seller of the CDS to make interest payments to the swap’s buyer should the underlying company be unable to make those payments on their own. The seller of the CDS, conversely, thinks the risk of default is relatively low, and is willing to make that bet with the buyer. The end result is insurance for said bond.

Problem: Neither the buyers or the sellers of bond insurance for Sears’ fixed income instruments believes the retailer will be able to make its required interest payments on those bonds within two years (and possibly even less time than that). Fortune’s Jeff Bukhari described it best on Tuesday:

“The price to insure $10 million of Sears bonds against default has risen to $4.6 million a year, meaning that holding the bond insurance-called a credit default swap-for a little more than two years will actually cost more money than the principle is worth, according to research firm IHS Markit. Over the full five-year term, it would cost $23 million to insure $10 million in bonds, meaning very few traders who are buying up the bond insurance think the company will last nearly that long. The cost per year was $3.3 million as recently as September, and was less than half a million dollars in mid-2013.

The implication of this wacky math coming from the obscure CDS corner of the bond market: Sears won’t make it much past Jan. 2019.”

Not good.

Yeah … But Why Now?

Still, the few remaining owners of SHLD stock and bonds are well aware of the risks. The retailer has been losing ground since 2007, and losing money since 2011, with no end in sight.

What could have suddenly spooked bond insurers?

Actually, it wasn’t quite as sudden as the one-day, 13% tumble that Sears stock took would imply. The cost of Sears’ CDS has been rising steadily for some time now. Granted, the cost of insuring these bonds only recently jumped past the bond’s underlying value very recently, but it wasn’t as if a switch was flipped.

Rather, the catalyst that had traders connecting the dots all of a sudden was very likely the simple fact that Bukhari penned and posted the observation on Tuesday.

Even Bukhari acknowledged the trouble for the retailer has been brewing for a while, with insolvency looming. Last quarter’s earnings report was just one more in a long string of increasingly ugly reports bringing it closer to that end.

Bottom Line for SHLD Stock

Exacerbating the problem may well be something yours truly pointed out in response to Sears dismal Q3 results from December:

“And the cash crunch is apt to get worse beginning in July. That’s when all of Sears’ secured loans and bonds will start to mature. They’ll all meet their maturity within three years after that. SHLD doesn’t have the cash it needs to service that debt, and creditors/lenders are increasingly hesitant to accommodate the failing retailer.”

The credit default swaps aren’t directly related to the impending maturation of the company’s debt. But indirectly, they add to the cash-crunch problem. Sears needs to refinance, but that may well be impossible to do.

In other words, the surge in the cost of insuring Sears’ bonds is ultimately rooted in the same frustration that SHLD stock holders have been suffering for years now: The company isn’t selling enough of the right merchandise at the right price in the right way at the right time. It’s increasingly struggling to pay its bills. That reality became a little more real — perhaps a little too real — on Tuesday.

The end is near.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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