Despite supply chain bumps, rapidly rising inflation, and labor shortages, 2021 marked one of the most positive years for U.S. retail and restaurant companies from a credit ratings perspective. Specifically, the global pandemic helped accelerate retailers' shift to online sales and provided an unexpected boost in pent-up demand last year to what was one of the most distressed sectors in U.S. corporate ratings pre-pandemic.

The vast majority of rating actions in 2021 were positive and this trend has continued so far in 2022. We expect retailers will continue to report sustained elevated demand going into 2022. Residual pent-up demand from 2021, still elevated excess savings, and a strong jobs market are supporting consumer spending. Despite higher costs in freight, labor, and transportation, retailers have been able to improve margins because consumers remain price inelastic. In addition, operating leverage and efficiency gains provide further uplift in profitability. We believe the current positive operating environment represents a high water mark for the sector and this is apparent in our portfolio of ratings as well: we started the year with only 4% of the portfolio rated in the 'CCC' category, which signals a 1-in-2 likelihood of default. This is the lowest default risk in the portfolio since 2014 and suggests the very low speculative-grade default rate will remain close to the 2% we saw in 2021 in retail, a dramatic recovery from the 20% default rate of 2020.

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In the years leading up to the pandemic, the retail industry was under tremendous duress. Brick-and-mortar icons filed for bankruptcy and many others closed doors and liquidated at an unprecedented pace. Further credit distress marked 2020, to be followed by a stark about face in 2021. Some supporting statistics:

• S&P Global Ratings' U.S. retail and restaurant team upgraded 47 companies and downgraded only 4 across the portfolio in 2021. In 2020, we upgraded 27 companies and downgraded 86.
• There were only 2 defaults or selective defaults, versus 19 in 2020 and 8 in 2019.
• We rated 25 new issuers in 2021, versus 17 in 2020 and 11 in 2019.
• Bellwether Amazon.com Inc. (AA/Stable/A-1+) saw a one-notch upgrade in June 2021.

That said, in our view the investment thesis for the sector has also changed and this will bring new risks in coming years. Pre-pandemic, private equity financial sponsors showed a downward arrow on debt leverage with an upward arrow of new-store growth as support. Now the view is online players are asset-lite, with limited or no stores and less capital spending and therefore better cash flows. Already in 2021, that spelled huge dividends after a short hold period, such as a $1.1 billion in distributions to shareholders and management for Mattress Firm Inc. (B+/Positive/--) within a year of a refinancing. Meanwhile, aggressive 2021 leveraged buyouts included:

• Apollo Global Management's acquisition of The Michaels Cos. Inc. (B/Stable/--) for a total consideration of about $5.5 billion (including equity and debt), with the transaction increasing the amount of funded debt on Michaels' balance sheet by $1.6 billion.
• Hellman & Friedman LLC's $2.9 billion tender offer for At Home Group Inc. (B/Stable/--), increasing funded debt by about $1.1 billion upon completion.

Offsetting these deals is the fact that many other companies in the sector are seeing generally lower net leverage, given high cash balances and a decision to use cash for debt reduction. We believe these are prudent moves in a persistently volatile operating environment that should provide some cushion to help avoid a return to high levels of distress for the space in the next one to two years. Aggressive shareholder-friendly share buybacks funded by rainy day liquidity could limit an issuer's ability to navigate a more dramatic decline in consumer spending in the second half than we expect.

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Restaurants across the ratings spectrum saw more upside than downside in 2021 as well.

• In investment grade: We revised the outlook on McDonald's Corp. (BBB+/Stable/A-2) and Starbucks Corp. (BBB+/Stable/A-2) back to stable from negative and upgraded Darden Restaurants Inc. one notch (BBB/Stable/A-2).
• In high yield: We upgraded IRB Holding Corp. (B+/Stable/--), Brinker International Inc. (BB-/Stable/--) and Wendy’s (B+/Stable/--) one notch.

We rated six new restaurant companies, two of which were Taco Bell franchisees (MIC Glen LLC (B-/Stable/--) and Pacific Bells LLC (B-/Stable/--), amid that brand's strong performance.

We note casual dining establishments saw a material shift in off-premises dining, a trend we see as potentially challenging in years to come as companies work to restore sufficient demand to continue to operate expensive big box restaurants profitably.

Brinker International Inc. (BB-/Stable/--) for instance, reported growth in its off-premises mix for Chili's to 46% of total sales for the first two quarters of fiscal 2021 (ended June 2021). For the same period in 2019, off-premise sales were approximately 17%.

Potential volatility due to geopolitical conflicts, the return of stringent quarantine measures, or the Fed's efforts to tame inflation pose risk to our forecast of a modest slowdown in consumer spending later this year. If any of these risks intensify, choppy financial markets could compound speculative-grade issuers' problems. Whenever a crisis emerges, S&P Global Ratings analysts frisk their portfolio of credits for any that may need to tap financial markets. We've collected a list of speculative-grade credits that have maturities of at least 10% of their reported debt in the next couple of years that would likely be on our watchlist.

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E-Commerce To the Rescue

Before the pandemic, we expected e-commerce sales penetration to grow to 10% by 2024, a figure we now expect to be closer to 20% by then. Over the course of 2021, most companies reported growth in e-commerce sales penetration from pre-pandemic levels. However, very few of them approached the peaks reached during the pandemic.

We note apparel retailers and grocers were able to retain a material portion of e-commerce sales in the pandemic, though department stores were not (chart 4). And across most sectors, margin dilution has offset rising e-commerce penetration as online orders come with higher shipping, fulfillment, and labor costs.

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With such high hopes pinned on e-commerce, activist investors have agitated for splitting it off from brick-and-mortar operations in the department store space. Omnichannel capabilities are critical for most retailers and department stores are no exception. The companies invested in digital channels before the pandemic to increase engagement, strengthen loyalty, and benefit from multi-channel customers who typically spend more in aggregate. The pandemic accelerated investment further and created opportunities to leverage retail footprints within the distribution network, providing a seamless customer experience. In our view, digital capabilities are an important part of a department store's long-term relevance with customers. Furthermore, the development of an all-in-one experience has led to interconnections between brick-and-mortar and digital sales, making a separation expensive and complex.