Payless ShoeSource bankruptcy is the latest blow for retail bondholders

Payless ShoeSource’s bankruptcy filing has propelled Fitch Ratings’ U.S. retail default rate higher and kept the sector on track for up to $6 billion of defaults this year in the latest blow to retail bondholders.

The rating agency’s trailing 12-month loan default rate for the retail sector has climbed to 1% in April from 0% in March and 0.5% at the end of February, according to the rating agency.

Fitch is expecting the rate to spike to 9% by year-end as retailers continue to struggle with slowing traffic, shrinking margins caused by steep discounting and the competition from juggernaut
 . Consumer behavior is also changing with experiences and services more in demand than “stuff”.

“Retailers have also suffered from the ebb and flow of brand popularity,” Fitch said in a report. “Negative comparable-store sales and fixed-cost deleverage have led to negative cash flow, tight liquidity and unsustainable capital structures.”

“All of this reinforces the need for a seamless shopping experience and highlights the importance of remaining relevant to core customers while constantly attracting new ones.”

— Diana Smith, associate director, retail and apparel, Mintel

Payless was one of nine retailers on Fitch’s “Loans of Concern” list, which comprises issuers with a significant risk of defaulting on their debt in the next 12 months. The other eight with combined loan debt of nearly $6 billion are Sears Holding Corp.
 with about $2.5 billion of debt, 99 Cents Only Stores LLC, Charming Charlie LLC, Gymboree Corp., Nine West Holdings Inc.; NYDJ Apparel LLC; rue21, Inc.; and True Religion Apparel Inc.

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Moody’s said in February that it has 19 names in its retail and apparel portfolio, or 14% of the total, that are trading at Caa/Ca, deep into speculative, or “junk,” territory. That is close to the 16% considered distressed during the 2008/2009 period, said retail analyst Charles O’Shea. The rise is part of a wider trend affecting sectors across Moody’s coverage that has retail replacing oil and gas as the most-troubled industry.

See: Number of distressed U.S. retailers at highest level since Great Recession

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Payless filed for chapter 11 protection on Tuesday with a $385 million debtor-in-possession loan, composed of a $305 million asset-backed loan and an $80 million term loan, that has been extended by existing lenders to refinance debt and provide $120 million liquidity during the restructuring. Payless became highly leveraged in a 2012 buyout and its debt burden has crushed it during a period of weak sales and cash flow.

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The company is planning to hold liquidation sales for 400 underperforming stores that will be closed and will try to renegotiate leases or close more stores. Payless has entered a pact with parties that own about two-thirds of its first lien and second lien debt, which would reduce overall debt by about 50%.

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The first lien loans were bid at 38 cents on the dollar on Tuesday and the second-lien loans at 13 cents on the dollar, suggesting low recovery prospects.

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Payless has joined a growing list of retailers to seek bankruptcy protection in recent months.

Eastern Outfitters, whose chains include Eastern Mountain Sports and Bob’s Stores, filed for chapter 11 protection last month, and The Limited filed in January, causing the company to close all its stores.

Other companies that have filed for chapter 11 or completely liquidated in the past year include Wet Seal, American Apparel, Aéropostale Inc.
 , +0.00% and Sports Authority.

Macy’s Inc.
Gap Inc.
Sears Holding Corp. and Guess Inc.
are among the retailers that have announced store closures in recent months. Macy’s and Sears are often anchor stores that are meant to draw traffic to malls and other shopping centers, and specialty stores like Gap depend on the boost.

As a household name brand, the Payless bankruptcy has disappointed some investors, who believed the discounter was somewhat cushioned from the stresses hitting the broader sector, said Diana Smith, associate director of retail and apparel at market research company Mintel. As a shoe retailer, it was also viewed as being immune to the Amazon threat as a product category that works well out of physical stores. Consumers typically want to try on shoes before they buy them, said Smith.

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That dynamic is changing, according to Mintel’s Men’s and Women’s Footwear September 2016 report, which showed 30% of shoe buyers are now more comfortable buying footwear online than they were previously.

“All of this reinforces the need for a seamless shopping experience and highlights the importance of remaining relevant to core customers while constantly attracting new ones,” she said.

The stress in the sector is hurting the buyers of retail debt. The Bank of America Merrill Lynch High Yield Super Retail Index is showing a negative return of 1.1% for the year to date. The broader US High Yield Master Index is showing positive returns of 2.7% for the same period.

In equities, the SPDR S&P Retail exchange-traded fund
 has lost 6% in the year to date, while the S&P 500
 has gained 6%.

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