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Gap Default Swaps Soar After Results Show Cash Flow a ‘Hot Mess’

Credit-default swaps on Gap Inc. (GPS) jumped to the highest level since July 2007 after the largest U.S. apparel chain cut its full-year profit forecast.

The cost to insure against a default on the San Francisco- based retailer’s debt rose 8.1 basis points to 192.5 basis points, according to CMA, the data provider owned by CME Group Inc. that compiles prices quoted by dealers in the private market. The swaps have gained 31 basis points since 11:30 a.m. yesterday, before Gap announced earnings.

The company, which issued bonds last month for the first time since June 2002, yesterday lowered its 2011 profit forecast to as much as $1.50 a share, 22 percent below its previous prediction. The lower forecast has “serious implications” for free cash flow, a measure of performance watched by bond buyers, according to Carol Levenson, a Chicago-based analyst for Gimme Credit LLC.

“It’s a hot mess and underscores our ‘deteriorating’ credit score and belief that bonds will underperform,” Levenson wrote in a note.

Gap’s $1.25 billion of 5.95 percent notes due April 2021 fell 0.1 cent to 98.4 cents on the dollar at 12:35 p.m. to yield 6.17 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The debt, which was sold to finance stock buybacks, is down from 100.5 cents on May 17. The chain’s stock sank 17 percent to $19.30 as of 12:51 p.m. in New York Stock Exchange composite trading, its worst slide in at least nine years.

Louise Callagy, a Gap spokeswoman, didn’t return a phone message and an e-mail seeking comment.

More Leverage

“Our confidence has grown that we need not be as conservative as we were,” Sabrina Simmons, Gap’s chief financial officer, said in a telephone interview last month on the day of the bond sale. “We don’t need any more cash to invest in our business. This is an opportunity to bring some leverage onto our balance sheet.”

Default swaps on Gap rose to the highest level since July 30, 2007, when it cost 195 basis points to insure the retailer’s debt, or $195,000 annually on a $10 million contract. Moody’s Investors Service rates Gap Baa3, one step above junk, while Standard & Poor’s grades the company a notch lower at BB+.

The cost of protecting U.S. investment-grade company bonds from default climbed after two days of declines as the Standard & Poor’s 500 Index halted a two-day advance and erased what would have been its first weekly gain of the month.

The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, climbed 1.1 basis points to a mid-price of 89.7 basis points as of 12:59 p.m. in New York, according to index administrator Markit Group Ltd.

Swaps Rise

Default swaps rose as the S&P 500 fell 0.4 percent to 1,338.14. The index closed last week at 1,337.77. The credit swaps index, which typically rises as investor confidence deteriorates and falls as it improves, has gained from 87.8 basis points on April 29.

The price of Markit’s CDX North America High Yield Index, which falls as investor confidence deteriorates, declined 0.2 percentage point to 102.4 percent of face value.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point is 0.01 percentage point.

To contact the reporter on this story: Zeke Faux in New York at zfaux@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net

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