By Tim McLaughlin
BOSTON (Reuters) - Putnam Investments has placed a large, concentrated bet that struggling U.S. shopping malls can transform themselves even as key tenants shut stores or file for bankruptcy.
So far, it is winning - to the chagrin of hedge funds like Alder Hill Management LP that are on the other side of the bet.
Putnam, a Boston-based mutual fund firm, holds more than $1 billion worth of derivatives tied to mortgages on shopping malls, office buildings and hotels, according to interviews and filings analyzed by Reuters.
One way Putnam gains exposure to the mortgages is through the CMBX Series 6 Index, which references a basket of 25 BBB- rated commercial mortgage-backed securities. There are about 46 shopping malls linked to the index, whose key tenants - Sears Holdings Corp and J C Penney Company Inc - have been closing stores at a rapid clip.
Putnam has been selling protection on the CMBX, which means it is betting that the mortgages referenced in the index will not go bad. Investors buying protection, including Alder Hill, are betting there will be loan defaults and writedowns on the same properties.
Putnam funds receive payments from investors shorting the CMBX index but are on the hook to pay those investors if borrowers do not make adequate mortgage payments or if there is a loan writedown.
The CMBX Series 6 index is generating returns of 6 percent, Brett Kozlowski, a portfolio manager on Putnam's fixed-income team, said in an interview. The trade does not involve any leverage, he said.
That performance has helped the $4.7 billion Putnam Diversified Income Fund rise nearly 5 percent over the past 12 months, beating 90 percent of peers, according to Morningstar Inc research. That fund discloses nearly $700 million in exposure to the CMBX Series 6. Other Putnam-managed funds have similar investments on a smaller scale.
Although Putnam has been winning, its investment strategy is not without risk. Retailers have struggled for years with consumers' changing tendencies and how to compete against online shopping behemoth Amazon.com Inc (NASDAQ:AMZN).
Nearly 9,000 major chain stores closed in 2017, according to real estate firm Cushman & Wakefield. That was more than double the number of closures in 2016, outpacing the record set in 2008 during the Great Recession, Cushman & Wakefield said.
The carnage has continued this year, with the Bon-Ton department store chain filing for bankruptcy and closing more than 260 stores. Its woes mirror rivals like Sears, which has closed more than 250 stores and continues to bleed cash.
Although Putnam realizes the retail sector is still having trouble, its investment strategy is partly based on the idea that shopping malls can transform themselves into different destinations, Kozlowski said. For instance, the Westside Pavilion outside of Los Angeles is converting square footage into office space.
The short sellers see a much grimmer future.
The CMBX Series 6 index would plunge 56 percent in a worst-case scenario outlined by Alder Hill in a July report. Even with limited store closures, the riskiest malls in the index will only be able to produce 45 percent of their 2017 operating profit going forward, the report said.
The New York-based hedge fund declined to comment.
The Emerald Square (NYSE:SQ) Mall in North Attleboro, Massachusetts, is one example cited in its report.
Alder Hill estimates the mall's value is less than outstanding debt of $104 million, hurting its chances for redevelopment like at Westside Pavilion.
"Emerald Square Mall is likely headed for a term default and a high severity loss for CMBS lenders," Alder Hill said.
Simon Property Group (NYSE:SPG) LP, which owns 56 percent of Emerald Square, was not available for comment.