Cloudy, with a chance of defaults

Default rates are projected to further rise next year in the retail industry as the number of companies on rating agencies' distressed watchlists grows, according to credit analysts.

Why it matters: If a recession is on the way, the first signs of it may be in consumer-facing sectors.

Details: Fitch Ratings projects that the retail default rate for leveraged loans could increase to 3% by the end of 2023 from 0.5% as of October, while the retail default rate for high-yield bonds could increase to 11% next year from 0%, also as of October.

• Retailers most vulnerable are those with high leverage, floating-rate debt and no hedges in place, says Raya Sokolyanska, a senior retail analyst at Moody's.
• They also sell discretionary goods and largely cater to lower- and middle-income consumers, she tells Axios.

Catch up fast: Investors have already witnessed a distressed debt exchange by Bed Bath & Beyond, another proposed by Rite Aid, a missed payment by Isagenix, as well as the bankruptcy of Sears Hometown Stores.

Flashback: There were 17 retail bankruptcies as of Dec. 15 in 2022, the lowest number in more than 10 years, according to S&P Global Market Intelligence.

Driving the news: November witnessed the first real downward shift in consumer spending, says Sarah Wyeth, retail sector lead at S&P Global Ratings.

• Retail sales during the month declined 0.6% versus October but increased 6.5% year over year against a 7.1% increase in the CPI.

Yes, but: "We struggle with different data points," Wyeth tells Axios.

• The job market remained strong in November, complicating analysts' outlook, she notes.
• And while the costs of freight and commodities are coming down, labor remains expensive, Wyeth says.

Between the lines: In particular, sales declined the most in home-related categories such as home furnishings, building materials and garden centers, Wyeth says.

• A number of home goods retailers are on the cusp of a CCC rating, which would give them a 50% chance of defaulting, she explains.
• Those include At Home, Michaels, Joann and Empire Today, all rated B- with negative outlooks, according to S&P (Moody's already has several of these issuers rated Caa1 or below).

Reality check: The uptick in defaults will follow a period of relative calm after a wave of pandemic-induced bankruptcies cleared out most of the banners with unsustainable debt loads, Sokolyanska says.

• That entails retailers that would otherwise still be struggling today such as JCPenney, Ann Taylor-parent Ascena and GNC, among others.
• Even retailers that didn't default took the opportunity to restructure their balance sheets, push out their debt maturities and close stores, says Fitch senior director David Silverman.
• Silverman, taking a more optimistic view, says, "We do think we will see a light recession, but we don’t think it will be consumer driven or that the consumer will be impacted."

What we're watching: Changes in unemployment, which is the big driver, Wyeth says.

• "As employment cools down, the question will be how that affects spending at the mid-to higher-income level," Sokolyanska says.

The bottom line: Whatever the retail default rate is for 2022, it will be lower than the 20% the industry notched in 2020, Wyeth notes

Editor's note: This story has been corrected by removing Bob's Discount Furniture from a list of home goods retailers on the cusp of a CCC rating, after the company responded after publication to say S&P had upgraded it.