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Gap Bonds Sink While Swaps Soar to Record Amid Profit Decline

Derivatives traders and bond investors are losing confidence in Gap Inc. as the largest U.S. apparel chain faces declining profit amid what the company said are the worst inflationary pressures in three decades.

Credit-default swaps on Gap soared to the highest ever today, according to data provider CMA. The San Francisco-based company’s 5.95 percent bonds due in 2021, the second-most actively traded today, fell 1 cent to 96.625 cents on the dollar at 1:47 p.m., the lowest since they were issued in April, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Gap Chief Executive Officer Glenn Murphy told CNBC today the company is facing inflationary pressure not seen in 30 years. The company cut its full-year profit forecast by 22 percent last month, saying expenses per unit will rise 20 percent in the second half, outweighing price increases. Barclays Capital cut its “overweight” rating on the company’s shares to “equal weight” today, citing “disappointing” first-quarter business trends and losses from Japan.

“They had some tough quarterly numbers recently,” said Sabur Moini, a money manager who oversees about $2.3 billion of high-yield debt at Los Angeles-based Payden & Rygel, including Gap debt. “Retail in general has been under some pressure. If the data continues to be weak, if employment data is weak and confidence is declining, retail and consumer names will get hit.”

Reports last week showed manufacturing in May expanded at the slowest pace in 20 months, unemployment rose to 9.1 percent and consumer confidence fell to a six-month low.

`Sound Financial Policy'

“We remain committed to maintaining a sound financial policy, strong credit profile and focus on liquidity,” Louise Callagy, a Gap spokeswoman, said in an e-mailed statement. “At some point, likely 2012, we believe we will turn the corner on these high cotton prices. This, coupled with the work we have done to streamline our operations and drive our growth initiatives, will fuel the opportunity to get back to 2010 operating margin levels over time.”

Callagy said the company’s strategy is unchanged and it believes “strongly in a balanced approach of managing the short term against our long term plan. Because of our strong financial health, our ability to consistently generate cash flow and our history of financial discipline, we will deploy designated growth capital as planned while managing the short term inflationary pressures. We are clear on our priorities and what it will take to drive improvements in North America as well as capitalize on our global growth opportunity over the long term.”

‘Flagship Revamp’

Comments Murphy made at a Piper Jaffray Cos. conference today may also have resulted in investors showing “disdain for the bonds,” according to Interactive Brokers Group LLC in Greenwich, Connecticut.

“Mr. Murphy spoke Wednesday saying the company didn’t get enough breaks considering its size and said as a result he’s turning his nose up at some vendors in order to perhaps get a better deal in the future,” Andrew Wilkinson, a senior market analyst at Interactive Brokers Group, wrote in a note. “He also ’fessed up to mistakes at the clothing retailer adding the cure for ailing sales is a flagship revamp in North America.”

Credit-default swaps on Gap’s debt, which typically fall as investor confidence improves and rise as it deteriorates, climbed 7.8 basis points to 218 basis points as of 12:28 p.m. in New York, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The contracts are up from 98.5 basis points at the end of last year.

Surging Cotton Costs

Fiscal 2011 profit will be as much as $1.50 a share, according to Gap, which previously forecast a maximum of $1.93 a share.

The apparel industry is raising prices amid surging cotton costs and increased pay for workers who make clothes in China and other parts of Asia.

That’s pressuring bonds from investment-grade consumer cyclical and auto companies, which have seen relative yields rise to 120 basis points as of yesterday from 114 basis points at the end of last year, according to Bank of America Merrill Lynch index data.

That compares with spreads on overall investment-grade debt, which have narrowed to 160 basis points yesterday from 166 basis points at the end of 2010, the index data show.

‘Well-Managed Retailer’

Gap’s senior unsecured notes are rated Baa3 by Moody’s Investors Service and BB+ by Standard & Poor’s. Proceeds from the bonds may be used for share repurchases, Moody’s said in an April 7 note.

Even with the sales declines, Gap is a “well-managed retailer,” according to George Ashur, managing director of credit strategy at Societe Generale SA. Gap’s $1.25 billion of 5.95 percent notes due 2021 represent “attractive value for cross-over buyers in the present market,” he wrote in a note yesterday.

The bonds had 25 trades of $1 million or more, trailing 26 trades of Teleflex Inc., Trace data show.

Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Gap declined 2.2 percent to $17.52 at 1:48 p.m. in New York Stock Exchange composite trading. The shares had dropped 19.1 percent this year before today.

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