It's often said that economic expansions don't die of old age--rather, something kills them. The same can be said about credit cycles. With the current cycle in the U.S. now a decade old, questions around what will trigger its demise are growing more relevant. But perhaps more important than the "what" is the "when." Given how late we are in the credit cycle, there are many factors that could wrap the market in prolonged volatility, forcing issuers with seemingly manageable maturities into a greater area of uncertainty and refinancing risk.
The recent debt binge has investors increasingly concerned about the ramifications if the credit cycle turns. The maturity wall is constantly shifting as issuers continue to opportunistically refinance at historically low spreads and overall rates. Right now, peak maturities are not coming due until 2022 (see chart 1). However, two key sectors are particularly vulnerable: retail and restaurants and oil and gas. They have some of the most debt coming due in the next couple of years, and a high percentage of that debt is speculative-grade (rated 'BB+' or lower). How did they get to this point and what might happen to them when the credit cycle turns?
Retailers Should Retool To Manage Upcoming Maturities
Retail and restaurants issuers have struggled over the past 18 months, with some borrowers unable to tap the market at favorable terms and conditions. Retail defaults hit a record-high in 2017 even as the economy remained solid, and there have been more thus far in 2018 than during the Great Recession. While not our base-case scenario, a protracted downturn in the credit cycle, coupled with substantial maturities coming due in the next couple years, may lock out many borrowers for good, leading to even more defaults.
Either way, structural shifts in retail--including the strong growth of e-commerce and changing consumer tastes--and their effects on credit quality for large swaths of the sector will continue to evolve in the next few years. Even barriers to entry have been softened by the ability to startup exclusively online. We think financial markets' appetite for retailer debt may well rest partly on how they view a company's ability to adapt in the longer term. The credit quality of rated retailers has weakened in recent years, as downgrades have outpaced upgrades due to greater competitive pressure and weaker profitability in the retail industry. In the U.S. there have been more than 100 downgrades since January 2017 (see "Stressed And Distressed Retailers: Looking Forward (Or Down) Past The Tipping Point," published Feb. 27, 2018).
Meanwhile, spec-grade debt has increased as a percentage of total maturities through 2024. Roughly $50 billion of the sector's spec-grade debt is coming due in the next three years--with more than two out of every five rated retailers in the 'B' category, one-third of ratings outlooks at negative, and about 17% of the portfolio in the 'CCC' category. Based on the current landscape and the large amount of spec-grade debt coming due in the next couple years, it's natural that concerns are increasing as we enter the 11th year of the credit cycle. Specialty retailers, especially those at the lower end of the credit spectrum, will need not only to adapt their business models, but also effectively manage their maturities in a rising interest rate environment.
Oil And Gas Is On The Upswing, But For How Long?
Since the last cyclical trough, access to the capital markets and pricing terms for the U.S. oil and gas sector have significantly improved. But volatile oil prices may limit some of the sector's attractiveness from an investing standpoint, and therefore pressure liquidity. This, coupled with significant maturities in the next couple years, could prove problematic for an industry still recovering from its recent downturn.
The industry faces massive refinancing needs in the next several years that could pose a significant risk if we see prices akin to 2015-2016, the lead-up to which involved investor appetite that can only be described as irrationally exuberant, brought on by the high oil prices, low interest rates, and booming prospects for U.S. shale production. Indeed, the amount of debt issued in the three-year period before Jan. 1, 2015, was historic (see chart 4).
After the November 2014 OPEC meeting, where it was decided that the group would try to protect market share and drive out the higher-cost U.S. producers by maintaining oil production, The ensuing decline in oil prices was unprecedented, while debt yields skyrocketed. Spreads on spec-grade debt peaked at nearly 14% (see chart 4). With those type of average spreads, companies with looming debt maturities--particularly at the lower end of the ratings scale--couldn't access the debt markets at palatable rates and had to rely on assets sales, draw down revolving debt, or initiate distressed exchanges. Subsequently, the number of companies filing for bankruptcy and the amount of debt defaulted upon was unprecedented in the sector's history. Law firm Haynes and Boone LLP has recorded 144 North American exploration and production company bankruptcy filings (as of March 31) since the beginning of 2015 totaling approximately $90.2 billion in secured and unsecured debt.
For oilfield services, Haynes and Boone has recorded 167 bankruptcies since the beginning of 2015, including secured and unsecured debt totals for each case. The total amount of aggregate debt administered in oilfield services bankruptcy cases from January 2015 through the first quarter of this year was approximately $58.5 billion, and the average debt of these cases exceeded $350 million.
Investors haven't forgotten this industry downturn and are punishing companies that grow production through significant outspending. They are much more rewarding of companies that exercise capital discipline and that can grow production within cash flow. Investors are also becoming more selective with some new issuance at the bottom end of the ratings spectrum, with some deals being delayed or cancelled due to investors demanding higher returns.
But higher oil prices have enabled issuers to opportunistically tap the capital markets again. In turn, the maturity wall has been pushed out to 2022, with over half the debt maturing coming from the high-yield market. After the recent wave of high-yield oil and gas defaulters, issuers have been able to delever their balance sheets in order to survive in lower-price environments.
Now as oil prices find some support, the sector is facing headwinds from the potential end of the current credit cycle. Spec-grade rated issuers have been relying heavily on access to the capital markets to fund their operations, with some companies locking in unsustainable rates on the new debt in order to continue operations. While not our base case, a protracted bout of volatility stemming from the credit cycle turning would spark heightened refinancing risk.
Anticipating The Turn
It's difficult to pinpoint a specific situation most likely to end what has been a historic run of favorable credit conditions. We've identified a few suspects, including the possibility of a full-blown global trade war, heightened financial market volatility, and the chance for faster-than-forecast increases in borrowing costs (see "Credit Conditions North America: U.S.-China Trade Strife Threatens Favorable Conditions," published June 28, 2018). Any one of these catalysts--or combination of them--could theoretically spark the next risk-off downturn.
The risk of refinancing remains manageable for now, especially in the investment-grade market, but strong bouts of volatility have been hitting the market throughout the year already, and further panic may be the spark that kills the current credit cycle. Given the considerable headwinds faced by both the oil and gas and retail and restaurants sectors, the maturity wall should be monitored closely as a downturn in the credit cycle would mean considerable trouble for both sectors.
As all in yields start to rise, the cost of debt for issuers will start to increase and therefore issuers may need to alter their capital structure. In response, companies might begin to lower debt or target lower key financial metrics such as debt-to-EBITDA. This would better position them to access the capital market going forward, but as these markets often end with a bang, so too companies may be caught off guard.
- Global Credit Conditions' Broad Stability Threatened By Potential U.S.-China Trade War, June 28, 2018
- Credit Conditions: North America March 2018--Trade Tensions, Market Swings Pose Risks To Benign Conditions, March 28, 2018
- Stressed And Distressed Retailers: Looking Forward (Or Down) Past The Tipping Point, Feb. 27, 2018
- U.S. Refinancing Study--$4.4 Trillion Of Rated Corporate Debt Is Scheduled To Mature Through 2022, Feb. 6, 2018
This report does not constitute a rating action.
|Primary Credit Analysts:||Jacob A Crooks, CFA, New York (1) 212-438-3183;|
|Robert E Schulz, CFA, New York (1) 212-438-7808;|
|Thomas A Watters, New York (1) 212-438-7818;|
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