There are plenty of reasons to be fearful. Recent earnings from leveraged retailers such as J. Crew and Guitar Center have revealed shrinking margins and declining sales, as consumers pivot towards experiences and travel instead of material goods.

In some cases, sharp drops in EBITDA have been punished by debt investors. The iconic guitar maker Fender, for example, saw a sharp sell-off in its debt after it reported third quarter earnings.

And yet, earnings at department stores like Macy’s, Neiman Marcus and Nordstrom are holding up better, at least on a relative basis. As retailers across the board struggle to grow sales and bottom line, debt investors seem drawn to larger, better capitalized names.

There are also signs that margin pressures could be easing. Shipping rates are dropping from their peaks, and retailers are selling through excess inventory (even if achieving that involves some aggressive price discounting in the near term).

Despite expectations that unemployment will rise after hitting a 50-year low earlier this year, some analysts are feeling more confident on consumer credit in general — partly because of hopes that inflation could be peaking.

The chance of a turnaround in retail credit depends on a handful of uncertainties — the path of inflation, the economy, consumer confidence and the success of the crucial holiday retail season, all of which remains unclear.

This is already drawing the meme-stock crowd, with retail investors on Reddit pitching trade ideas for heavily discounted debt of companies like Bed Bath & Beyond. Whether institutional investors will brave the same uncertainty through the crucial holiday period remains to be seen.

“Performance is still good, the consumer still hanging in and still spending,” said one retail-focused leveraged finance banker. “But you don’t know how the holiday season will be.”

Holiday sales

Retail bonds have racked up losses of around 16% this year to date, versus around 9% for the overall high yield index, according to JPMorgan analysts.

That makes it one of the worst performing sectors in leveraged credit. Still, it’s worth pointing out that this is at least partly the result of idiosyncratic issues at a handful of names.

Investors have been extremely unforgiving when it comes to names like Party City and Bed Bath & Beyond, However, several sources speaking with 9fin attributed these companies’ issues to years of excessive leverage (and flat-footed management), rather than today’s macro pressures.

“I don’t think the higher costs we’ve seen are what is causing companies all of a sudden to have liquidity issues,” said one credit analyst. “But if you were already on the knife edge with too much leverage, facing these additional headwinds makes things more difficult.”

Bed Bath & Beyond’s long-dated bonds are trading at 15 cents on the dollar, and the company is technically in default; Party City’s $750m 8.75% SSNs due 2026 are trading at around 37, as the company reportedly holds talks with creditors (see full financials for both issuers on 9fin).

Beyond these situations, there are plenty of storied retail names — like J. Crew, for example — facing new pressures like high shipping and labor costs (also a problem for healthcare credits) and weaker consumer demand compared to last year’s bumper retailing environment.

“Last year was a perfect storm of profitability,” said one buyside analyst. “All these guys are comping against a year of zero promotion, and the highest merchandise margins of all time.

“Now you just have to promote more, with a consumer that is already stretched. In a regular-way economy, if companies had too much inventory I wouldn’t be as concerned.”

Making the best of it

Some companies however have been able to weather these pressures better than others.

Bath & Body Works, for example, exceeded estimates in its latest earnings report, generating $1.6bn in sales. That was down 5% from the third quarter of 2021, but up 46% from the same period in 2019.

One credit analyst took this as a sign that the company had expanded its customer base through the pandemic; customers may have shifted from buying sanitizer products to things like home fragrances, but ultimately they remain loyal customers.

“If you look back over the last 10 years, the company has been pretty consistent,” said one portfolio manager. They’ve had a low double-B balance sheet, a consistent financial policy and they’ve been pretty well run.”

Some retailers, meanwhile, are seen as rising stars. One example is Macy’s (currently rated Ba1/BB+/BBB-) which was recently upgraded by S&P to BB+ from BB. In its upgrade report, the ratings agency cited Macy’s progress on deleveraging despite sector headwinds.

There are also some specialty sub-sectors of retail that seem to be benefiting in the post-pandemic economy: pet care is a particularly clear example.

Privately owned retailers PetCo and PetSmart are both expected to benefit from booming pet ownership in the US. In total, animal lovers generated $60bn of spending on pet care in 2021, an increase of nearly 16%, according to data from NielsenIQ.

Similarly, some analysts are upbeat on the outlook for Apollo-owned arts and crafts retailer Michaels Stores.

The company has struggled with higher freight and shipping costs, which has weighed on EBITDA. Its bonds are trading at deeply discounted levels, with the $1.3bn 7.875% 2029 senior notes last trading at just 59 cents on the dollar.

Yet according to one retail analyst, markets are overlooking the fact that Michaels has a reasonable capital structure and that “crafts are relatively defensive”.

Bad vs…less bad

Some investors see an increasing bifurcation in retail credit. There are bright spots within the sector, but it’s a low bar.

Macy’s net sales, for example, were still down 3.9% year-over-year in the third quarter, while Nordstrom’s net sales were down 2.9% over the same period. Pete Duffy, CIO of credit at Penn Capital, said this had important implications for credit more broadly.

“They’re not tremendous [numbers] unto themselves, but some of them have done better than low expectations ,” he said of the Macy’s and Nordstrom numbers. “To us that means the high end consumer is doing ok.”

Investors are also more forgiving of well-capitalized names, even if earnings are falling.

Abercrombie & Fitch, for example, reported a net loss of $2.2m in the third quarter, compared with income of $47m in the same period of 2022. Yet the company’s only outstanding bond, a $350m issue of 8.75% SSNs due 2025, rose 3-4 points on the earnings, to trade around par.

Investors are focused on the company’s strong liquidity. A&F reported $257m of cash plus ABL capacity for total liquidity of $617m; one credit analyst said this suggests the company could potentially call its bond in 2023 without needing to refinance it.

Cleaning up

Some of the factors that have weighed on retail credit this year could be subsiding. For one thing, falling freight costs could ease some of the margin pressure on retailers heading into 2023.

The Freightos Baltic Index, which tracks global freight costs, is down to $2,528 as of December 2 after peaking at $11,109 in September 2021.

“The headwind that definitely compressed gross margins for a couple of businesses should now be subsiding,” said John Park, a high yield credit analyst at T. Rowe Price. “But there's a lag time, so products that companies are procuring now [with lower freight costs] won't hit the shelves and P&L until some time in 2023."

There could be some relief on labor costs, too. Although the push for a $15 hourly minimum wage drove labor costs up across most major retailers in 2021, several analysts said they did not expect them to continue to rise next year. Even if they do, for some retailers higher wages are a positive tailwind because they give customers more disposable income, one analyst noted.

And then there’s sales. While there’s an obvious risk (and probably a general expectation) that the US enters a recession next year, there are also indications that inflation could be peaking. In the grand scheme of things, this may ease pressures in consumer credit.

Some data also suggests consumer spending ticked up in October, and that Black Friday sales may be better than initially feared.

On the flipside, some market participants are wary of the risk that this year’s decline in discretionary spending — which started among less affluent consumers but then began to spread — will continue to bleed more into the higher echelons of the retail market.

“For the clients I work with, Black Friday and Cyber Monday were not outstanding,” said one financial advisor focusing on consumer-facing brick and mortar businesses. “In the earlier part of the year the affluent customer was unfazed but that is starting to change a bit.”

Existential angst

Beyond these quarter-on-quarter challenges, some investors still remain cautious on retail because of the longer term issues that companies in the sector have struggled with for years.

One only has to look at the likes of Sears or JC Penney to see why there’s hesitation on buying long dated bonds from companies tied to brick and mortar retailers.

“This is a sector that skews towards businesses that have secular question marks,” said Park at T. Rowe Price. “When you have a weak market, anything that’s secularly challenged rightfully gets sold off aggressively.”

This year’s Black Friday broke records for online sales. But visits to indoor shopping malls on Black Friday were down almost 14% compared with 2019 levels, according to commercial real estate data firm Placer.ai. The slump at outlet malls was even more severe, with footfall dropping 18%.

An additional concern for mall-based business like Macy’s or Nordstrom, one credit analyst said, is the risk that companies take advantage of loose covenants to boost shareholder returns at the expense of creditors.

Macy’s has so far resisted pressure from activist investors to spin-off its valuable e-commerce business; however, this kind of risk is front of mind for debt investors.

"You have to have a maximum defensive view on retail names given everything that’s going on in the economy,” said Park.

And when it comes to loose covenants, what does the worst-case scenario look like? To answer that question, take a look at 9fin’s analysis of value leakage to find out what it means to be “J-Screwed”.