The retail and restaurant sectors have been under stress for years. The default rate of speculative-grade issuers in these sectors has been 10% since 2017, when the U.S. and Canadian economy was still in its expansionary period. This compares to a more typical default rate of 2%-3% in the corporate sector during such benign times. Secular pressures from the growth of e-commerce, increasing competition for share of wallet, and the generational shift of spending on experiences have weighed on the retail sector. In restaurants, competition from grocers' prepared food offerings, changing millennial dining preferences, and delivery cost pressures have challenged the traditional casual dining and quick service restaurant (QSR) models. These pressures and private equity piling on debt have driven many restaurant ratings down over the past several years.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

When the COVID-19 pandemic struck and the shutdown to contain it hit the U.S. in March, the risks in the retail and restaurant sectors spiked dramatically, as evident in S&P Global Ratings' rating actions. From early March through mid-June, we took nearly 100 negative rating actions directly related to the impact of the pandemic across a universe of about 130 rated entities, about two-thirds of which were downgrades (see chart 3). The negative bias in our portfolio has nearly doubled (see chart 4). The vast majority of our rating actions were on speculative-grade companies (rated 'BB+' or lower) which tend to be less stable than investment-grade companies ('BBB-' or higher ratings), but the increase in potential fallen angels (companies rated 'BBB-' with negative outlooks or ratings on CreditWatch with negative implications) to five from zero speaks to the profound impact the pandemic has had across the credit spectrum. Macy's Inc. (B+/Negative/--) entered the pandemic as a fallen angel after we downgraded it to 'BB+' in February due to strategy execution risk amid secular headwinds. We subsequently lowered Macy's three more notches to 'B+' as the scope of the pandemic's impact unfolded. We also lowered more than 20 companies into the 'CCC' category. One fourth of the companies in the sector are now in the 'CCC' category, implying the default rate will be substantially higher than in recent years. In fact, the 16 defaults year-to-date has already surpassed all of 2019. If there are no more this year, the spec-grade default rate would be about 18%.

Chart 1

Chart 2

Chart 3

Early in the pandemic, market volatility put companies facing liquidity concerns and tightening covenant headroom at risk. Proactive revolver draws across the sector provided quick access to cash, but increased the risk of covenant breaches. As credit markets stabilized following intervention by the U.S. Federal Reserve, investment-grade and speculative-grade issuers capitalized on the opportunity to refinance near-term maturities, bolster cash on hand, and seek covenant relief. This relief has taken different forms, including temporarily suspending and/or waiving financial maintenance covenants tests, redefining covenant calculations to include the prior year's earnings, and adding new covenants in place of existing ones, such as minimum liquidity requirements.

Table 1

The Default Rate Will Hinge On The Shape Of The Recovery

In our view, 2020's default rate will depend largely on the trajectory of the recovery. If recent improvements gain momentum--that is, if consumers continue to spend even after government support expires, and the virus is largely contained, we would expect the spec-grade default rate to creep up only slightly from where it stands today (about 18%) and believe most of the defaults would have occurred by this point. However, if a resurgence of the virus and another round of shutdowns further damages consumer confidence, and in turn financial markets falter, we could see the default rate approach 30%. This includes exchanges that we view as tantamount to default. We would expect the bulk of these to be concentrated in the hardest-hit areas of the sector: apparel and casual dining.

We recently updated our economic forecast to reflect what we believe will be an extended and nonlinear road to recovery (See "Economic Research: The U.S. Faces A Longer And Slower Climb From The Bottom," June 25, 2020, and "Economic Research: Canada's Economy Faces A Patchy Recovery," June 29, 2020).

Some bright spots exist

Despite the grim economic outlook, pockets of retail and restaurants have fared relatively well. The biggest winners have been grocers and other retailers that offer staples, who have benefitted from the stay-at-home mandates as consumers stock pantries and general merchandise, including cleaning products. We've also noted that some specialty retailers of products widely considered discretionary have fared better than we expected while others continue to struggle. A driving factor of which camp a retailer falls into is whether the products are intended to be used at home. For instance, some retailers who serve the home improvement, home decor and furnishings, gardening, fitness and outdoors, and the home office and electronics markets have shown positive trends or green shoots, despite in many cases having had to close their physical stores and pivot to imperfect e-commerce operations that had to be scaled up overnight. However, we are cautious about early positive trends coming out of the shutdown because we believe some consumer spending has been supported by government programs in the U.S., including generous unemployment benefits which will roll off by the end of July.

Table 2

Another pocket of better-than-expected performance is the quick service restaurant (QSR) sector. Several QSRs have posted positive comps or are rapidly approaching last year's topline. These companies are well-positioned for social distancing mandates and economic weakness. Off-premise operations including take-away, delivery, and drive-thru, enabled QSRs to capitalize on consumers who wanted to take a break from cooking at home while dining rooms were closed. With capacity limited at dine-in restaurants and consumers' lingering wariness of the virus, off-premise operations are likely to continue to take share and benefit from healthy demand. Casual diners have made headway in shifting operations to serve off-premise demand partly via third-party delivery services (see chart 4), but until they can open to full capacity and diners are ready to return, we believe they will continue to be well behind QSRs' performance (see table 3). Historically, QSRs have shown resilience to economic downturns as consumers carefully watch their spending and trade down from full-service dining experiences. This dynamic bodes well for QSRs given the slow economic recovery we expect although offsetting risks include a weak breakfast daypart because of altered commuting habits and high unemployment. We believe credit metrics could be restored for QSRs in the first half of 2021, but casual diners will likely need until late 2022 to bring back credit measures.

Table 3

Chart 4

Uncertain prospects for most of the sector

While we are still focused on the many near-term risks cited earlier, if the recovery gains momentum, we believe we could take positive rating actions including revising outlooks to stable from negative on QSRs and retailers that cater to homebound life in the coming months. For instance, we recently upgraded Carrols Restaurant Group Inc. (B-/Negative/--) to 'B-' from 'CCC+' on improved liquidity and performance. Still, the rating outlook is negative, reflecting our view that prospects for the majority of retailers and restaurants remain uncertain with risks to the downside. In the grocery sector we recently upgraded two companies: BJ's Wholesale Club Holdings Inc. (BB-/Positive/--) and The Fresh Market (CCC+/Negative/--), both due in part to a surge in sales.

Related Research

• Specialty Premium Grocer The Fresh Market Upgraded To 'CCC+' On Lower Near-Term Refinancing Risks, Outlook Negative, July 9, 2020
• Economic Research: Canada's Economy Faces A Patchy Recovery, June 29, 2020
• Economic Research: The U.S. Faces A Longer And Slower Climb From The Bottom, June 25, 2020
• Carrols Restaurant Group Inc. Upgraded To 'B-' On Debt Issuance, Improved Liquidity And Performance; Outlook Negative, June 24, 2020
• Macy's Inc. Lowered To 'B+' As Prospects Dim On Weaker Economy And Post Pandemic Uncertainty; Outlook Negative, April 24, 2020
• Macy's Downgraded To 'BB' As Economic Uncertainty Weakens Credit Metrics; Outlook Negative, March 25, 2020
• Macy's Inc. Ratings Lowered To 'BB+' On Strategy Execution Risks And Intensified Secular Headwinds; Outlook Stable, Feb. 18, 2020