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Leveraged Finance: U.S. Leveraged Finance Q3 2020 Update: Pandemic-Induced Borrowing Dilutes Recovery Prospects And Lessens Interest Coverage

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Leveraged Finance: U.S. Leveraged Finance Q3 2020 Update: Pandemic-Induced Borrowing Dilutes Recovery Prospects And Lessens Interest Coverage

As short-term borrowings at the onset of the pandemic are starting to look permanent, in this quarterly installment, we take the pulse of issuers' abilities to meet their interest obligations, which we consider of the utmost importance in our assessment of issuer creditworthiness and pivotal when assessing the health of today's credit markets. Trend analysis for the first half of 2020 reveals EBITDA-to-interest coverage ratios are in steady decline despite near-zero interest rates. Other than sharp drops in EBITDA, such strain can also be attributed to the aggressive borrowing before the pandemic and has since been exacerbated.

We also follow up on the pandemic's effect on recovery outlooks, delving into the dominating factor that drove recovery movements. About two-thirds of the downward revision were caused by changes to the capital structure, including debt add-ons (given the strength of investor appetite for more leverage notwithstanding the recession) or reshuffling of priorities--followed by steep and permanent enterprise value erosions. As is typical, the most extreme movements were the result of distressed restructures, whereby minority creditors experienced the highest swing after falling victim to priming liens.

Lastly, as the volume of leveraged loans experienced a resurgence, we saw recovery estimates of first-lien new issues stabilize. The average third-quarter recovery was in line with pre-pandemic levels and down sharply from its short-lived peak in the second quarter.

Deteriorating Interest Coverage Will Remain A Negative Overhang

The pandemic has intensified the U.S. economy's heavy reliance on debt, a trend long evidenced as a result of low borrowing costs. This could be problematic for companies already stretching to pay their interest bills. We illustrate how much the pandemic-driven borrowing affects companies' abilities to service their debts (tables 1 and 2). We show the transition of the median interest coverage ratio (calculated as reported EBITDA over interest expense) for 2019, as well as the 12-month periods ended March 31, 2020, and June 30, 2020.

  • Interest coverage has continued to descend this year, and the pace accelerated in the second quarter. The median of the full sample deteriorated further in the second quarter (table 1), compared both to 2019 and the quarter-ago period, based on a pool of nearly 900 corporate entities in the U.S. and Canada that were rated in the 'BB' ('BB+', 'BB', 'BB-') or 'B' ('B+', 'B', 'B-') categories as of mid-October 2020.
  • There was more relative deterioration at the upper end of the quality range. The median interest coverage ratio for companies rated 'BB+' and 'BB' ended the second quarter at 6.0x and 4.9x, respectively, each down 0.7x from year-end 2019. This group includes high-profile fallen angels Ford Motor Co., Occidental Petroleum Corp., and Kraft Heinz Co., all joined the speculative-grade space in the first half of 2020 and had a collective $190 billion of debt.
  • In contrast, the lowest rung 'B-' rated issuers saw little to no change. This is because the bottom tier only has so much cushion before being downgraded to the materially weaker 'CCC' category, at which point we believe there's at least a one-in-two likelihood of default, or one-in-three if we expect a default within the next 12 months. In fact, the most vulnerable 'B-' rated companies sit wobbly only half a turn above the 1.0x crucial threshold, meaning they have limited debt capacity for future liquidity needs, likely leading to an unsustainable capital structure if the cost of borrowing were to rise.

Table 1

Interest Coverage Slid In First-Half 2020, Exposing The Fragility Of 'B-' Rated Issuers
Median EBITDA interest coverage (x)*
Issuer credit rating Entity count 2019 Annual (fiscal year ended Dec. 31, 2019) 12 months ended March 31, 2020 12 months ended June 30, 2020
BB+ 73.0 6.7 6.3 6.0
BB 98.0 5.6 5.3 4.9
BB- 92.0 5.0 4.9 4.6
B+ 112.0 3.9 3.7 3.2
B 243.0 2.5 2.5 2.3
B- 277.0 1.6 1.6 1.5
Total 895.0 2.9 2.8 2.6
Data as reported in company's financial statements, without adjustment by S&P Global Ratings; data comprise a significant sample of 'BB' and 'B' category rated non-financial corporates in the U.S. and Canada. Data based on rating as of Oct. 15, 2020. Source: S&P Global Ratings.

Further breaking down the transition by sector shows uneven distress:

  • The trend of deterioration was more pronounced in the 'BB' category than among the 'B' category rated entities.
  • Five sectors including forest products, building materials, and mining and minerals showed modest improvement over the six-month span. Some rebound in these sectors, combined with cost-cutting measures and reduced benchmark rates, have more than offset the elevated borrowing.
  • Among entities rated in the 'BB' category, already-struggling retailers were hit harder than others, and they lost more than half of their pre-pandemic coverage. This group includes Nordstrom Inc. ('BB+'), Burlington Stores Inc. ('BB'), and The Gap Inc. ('BB-'), all of which fell sharply from 2019, though there are some signs of bottoming out.
  • In the 'B' category, notable declines were contained in the most cyclical sectors, such as oil and gas (declined 1.6x over the first half of 2020); auto/trucks (1x); media, entertainment & leisure (0.8x); and transportation (0.7x). For the most consumer-facing auto, airlines, and cruise operators in this group, we expect their path to pre-pandemic performance could take until 2023 and beyond. On the other hand, the technology sector, which held up fairly well, saw coverage edge up slightly.

Table 2

Distress Diverged Across Ratings And Sectors
Median EBITDA interest coverage (x)
Issuer credit rating of 'BB+', 'BB', or 'BB-' Issuer credit rating of 'B+', 'B', or 'B-'
Industry Entity Count 2019 (fiscal year ended Dec. 31, 2019) 12 months ended March 31, 2020 12 months ended June 30, 2020 Trend Entity Count 2019 (fiscal year ended Dec. 31, 2019) 12 months ended March 31, 2020 12 months ended June 30, 2020 Trend
Aerospace/defense 7.0 6.3 6.3 4.8 Downward 14.0 1.9 1.7 1.5 Downward
Auto/trucks 11.0 7.3 6.4 5.7 Downward 22.0 2.9 2.7 1.8 Downward
Business and consumer services 18.0 5.1 5.4 5.6 Upward 56.0 1.8 1.8 1.9 N/A
Capital goods/machine and equipment 32.0 5.6 5.4 4.9 Downward 65.0 1.8 1.9 1.9 N/A
Chemicals 16.0 4.6 4.9 4.4 N/A 19.0 2.3 2.5 2.5 N/A
Consumer products 16.0 5.9 5.1 4.3 Downward 49.0 2.2 2.1 2.3 N/A
Forest products, building materials, packaging 20.0 5.4 5.7 6.1 Upward 27.0 2.6 2.7 2.6 N/A
Health care 9.0 5.7 5.5 5.3 Downward 88.0 1.8 1.7 1.7 N/A
Media, entertainment, and leisure 35.0 5.0 4.8 4.4 Downward 86.0 2.8 2.5 2.0 Downward
Mining and minerals 11.0 5.2 6.8 6.0 Upward 27.0 3.5 4.0 3.2 N/A
Oil and gas 14.0 9.6 8.8 6.6 Downward 26.0 6.1 5.9 4.5 Downward
Restaurants and retailing 13.0 9.0 5.6 4.0 Downward 38.0 2.3 2.3 2.3 N/A
Real estate 12.0 4.2 4.3 4.2 N/A 4.0 3.3 3.0 3.4 N/A
Technology 23.0 6.9 5.6 5.3 Downward 66.0 1.4 1.6 1.7 Upward
Telecommunications 18.0 4.3 4.5 4.8 Upward 22.0 2.5 2.4 2.5 N/A
Transportation 8.0 5.8 5.6 4.8 Downward 23.0 2.9 2.6 2.2 Downward
Total 263.0 5.6 5.5 5.0 Downward 632.0 2.2 2.1 2.0 Downward
Data as reported in company's financial statements, without adjustment by S&P Global Ratings. Data based on rating as of Oct. 15, 2020. N/A--Not applicable. Source: S&P Global Ratings.

Recovery Rating Movements Were Less Frequent And Of Lesser Magnitude Than Issuer Credit Rating Changes

To gauge the pandemic's effect on recovery, we track changes to the recovery assessment of loans that serve as collateral for broadly syndicated collateralized loan obligations (CLOs) in the U.S. The second and third quarters saw massive rating actions on corporate borrowers in the shadow of pandemic. Compared to entity-level rating changes, the effect on recovery assessments has been far less. We analyzed the magnitude of changes to recovery point estimates since the beginning of April 2020, shortly after the coronavirus outbreak caused a major disruption in the U.S. economy (table 3).

Specifically, of all the loans that are held in U.S. CLOs that we rate, we revised recovery estimates on only a small fraction (204 loans) within the past two quarters, and of those, half were in the smallest band of 5% (table 3). Changes of this magnitude are modest and less likely to trigger a shift in recovery rating category. For the small percentage that saw a change in excess of 25%, the bulk was a direct result of distressed debt restructuring. That is because rescue financing facilities granted new lenders lien priority on the collateral, putting them ahead of the existing senior secured lenders. The resulting subordination outweighed the benefit of new capital infusion and dragged down the recovery rating of existing term loan by multiple notches (more on this topic in section "New capital structure via exchanges").

Table 3

Large Swings Are Exceedingly Rare
Senior secured loans with changes to recovery point estimates by magnitude
Magnitude of change in recovery point estimate Count %
5% 101.0 49.5
10% or 15% 74.0 36.3
20% or 25% 21.0 10.3
30% or greater 8.0 3.9
Total 204.0 100.0
Senior secured loans in broadly syndicated loan collateral with recovery movements in the second and third quarters of 2020. Source: S&P Global Ratings.

New Debt, Deteriorating Performance, And Capital Structure Changes Are Key Drivers Of Diminishing Recoveries

Tables 4 and 5 list the direct trigger behind movements of 10% or more in either direction. We recognize that the underpinning driver of recovery estimate changes was rarely singular. For example, while a direct trigger was incurrence of new financing, the need for additional liquidity may well be caused by severe performance deterioration stemming from disruptions caused by the pandemic. Of the 68 loans that experienced negative changes to recovery estimates, 41% pertained to the incurrence of pari passu debt. Another 32% related to severe underperformance that led to material value erosion, with the balance mostly pertaining to capital structure shifts (table 4).

Table 4

Key Drivers Of Negative Changes To Recovery Estimates
Count %
Incurrence of new senior secured debt pari passu to the existing 28.0 41.2
Severe performance deterioration or enterprise value erosion 22.0 32.4
New capital structure in place following distressed debt restructuring or incurrence of priority debt priming the existing 10.0 14.7
New capital structure in place following IPO, divestiture, or opportunistic debt exchange 4.0 5.9
Significant increase in usage of existing line of credit 3.0 4.4
Others 1.0 1.5
Total 68.0 100.0
Senior secured loans in broadly syndicated loan collateral with recovery movements in the second and third quarters of 2020. Particularly, this table shows loans with recovery point estimate changes of 10% or more, where rationale was disclosed in the research update. Source: S&P Global Ratings.
Incurrence of new secured debt that is pari passu to existing debt

Recovery prospects are susceptible to additional debt. Even on a pari passu basis, they dilute the finite collateral pool for the existing secured lenders. As in most cases where we held valuations unchanged, such extra debt load and the resulting dilution contribute to a meaningfully lower expectation in recovery rates. Loan documentation today often builds in a fair amount of future debt capacity, both in the form of a new facility or a fungible add-on to the existing tranche, permitting a borrower to incur a non-trivial amount of additional secured debt from day one. This laid the groundwork for incremental secured debt in this downturn. Companies made a dash for cash early in the pandemic, securing new financing to weather the storm. In the third quarter, when liquidity was no longer the priority, some shifted their focus to opportunistic transactions, evidenced by an uptick of dividend recapitalizations. In isolation, dividend recaps add strain to recovery prospects for all lenders because they raise leverage without offseting EBITDA.

Severe performance deterioration that led to permanent enterprise value erosion

We reduce our estimate of enterprise value at emergence when the business erosion is acute and long lasting to the extent that it materially exceeds our expectations, or if we believe the pandemic will lead to a permanent degradation in profitability. This was achieved through lowering assumed EBITDA level at emergence, reducing the EBITDA multiple, or in most serious cases, both. Sampling and packaging provider Bioplan USA Inc. is an example of a company caught by the fallout of the pandemic. It came into the crisis already with some disadvantages compared to its competitors: Its product distribution heavily depends on the print and retail industries, which are facing secular pressures. In addition to the retail shutdown, the company has suffered a severe blow in this downturn. Accordingly, we lowered the EBITDA multiple to 5.0x from 5.5x as we now expect recovery of 55% on its first-lien term loan, down from 70%. As for most entities suffering from deteriorating performance that ultimately led to a lowering of recovery assessment, the ongoing macroenvironment is having a resounding effect on their finances, in some ways that make the pre-pandemic days almost unrecognizable.

New capital structure via exchanges

A reshuffling of capital structure is another major cause of big swings in recovery ratings. Slashed earnings and plummeting oil prices tied to the pandemic have amplified the debt burden for many borrowers, resulting in a number of high-profile distressed exchanges in the third quarter. The implication on minority creditors could be devastating. As mentioned earlier, rescue financing facilities almost always come in the form of super-priority debt. Furthermore, existing lenders participating in the rescue financing were allowed to roll up a portion of their current debt into the new super-priority facility, further disadvantaging lenders who did not participate in the recapitalization. Whether these moves are permissible under the credit agreement is being challenged fiercely in court, as in the cases of Serta Simmons Bedding LLCand Boardriders Inc. Both are the latest examples of weakening creditor protection in an era of loose loan documentation.

In a different scheme that brought equal grief to minority creditors, issuers transferred collateral to the unrestricted subsidiaries in order to secure new financing. Here, we profile Party City Holdings Inc., which designated its Anagram International subsidiary (a designer, manufacturer, and marketer of metallic helium balloons) as an unrestricted subsidiary in conjunction with a notes exchange. This maneuver allowed the company to raise fresh capital against the now unencumbered Anagram assets. We have since revised our recovery rating on Party City's term loan significantly downward to reflect the structural subordination and that Anagram's assets are no longer part of the loan collateral.

Debt Reduction And Improved Operating Prospects Are Key Drivers Of Rising Recoveries

Despite the harsh operating environment, we have detected 20 loans that saw positive changes to recovery estimates in the second and third quarters (table 5).

Table 5

Key Drivers Of Positive Changes To Recovery Estimates
Count %
Debt repayment via cash, junior debt financing, or equity offerings 9.0 45.0
Operating prospects significantly improved beyond our expectations 4.0 20.0
Revised enterprise value and/or debt structure following sizable acquisition 3.0 15.0
Debt repayment via sale of business 2.0 10.0
Others 2.0 10.0
Total 20.0 100.0
Senior secured loans in broadly syndicated loan (BSL) collateral with recovery movements in the second and third quarters of 2020. Particularly, this table shows loans with recovery point estimate change of 10% or more, where rationale was disclosed in the research update. Senior secured loans are in BSL collateral pools. Source: S&P Global Ratings.
Debt reduction via refinancing mix

Companies' capital structures are continually evolving. Among loans with improving recovery estimates, 45% have been partially repaid using proceeds from unsecured debt issuance or equity offerings. This reduces senior secured debt as a percentage of total debt; the addition of junior debt provides loss-absorption cushion, and together, they raise recovery for the remaining portion of the secured debt.

Operating prospects significantly improved beyond our expectations

Although not as prevalent as the widespread economic hardship, some companies were in position to capitalize on the pandemic. Fender Musical Instruments Corp. rode the coronavirus wave to deliver operating results that significantly exceeded our expectations. This was led by online sales of entry-level guitars, which likely benefited from the lack of entertainment options available to consumers staying at home, and it appears many consumers used the time as an opportunity to learn how to play a new instrument. That said, bright spots like this are company-specific and are of no match to the magnitude of the negative moves.

Recovery Prospects For First-Lien New Issues Revert To Three-Year Average

Chart 1 illustrates the recovery trends of first-lien new issues, measured by the quarterly average of recovery estimates. By and large, recovery outlook has been stable, fluctuating in a narrow band of 64%-67% since the second half of 2017. With the loan market having further stabilized and normalized in the third quarter, the average recovery estimate of first-lien new issues reverted to the mid-60s percent area, down from 71% a quarter ago (chart 2). Part of this sharp reversal was because of a shift in the borrower quality mix; the new vigor in leveraged loans came hand-in-hand with investors once again embracing lower-quality assets. In the third quarter, 77% of first-lien new issues by issue count were from 'B' category rated entities, compared with 51% in the second quarter, when an influx of high-quality debt from 'BB' category entities lifted the recovery average to a three-year peak. As mentioned in our second-quarter 2020 report (U.S. Leveraged Finance Q2 2020 Update: Recovery Ratings Maintain Social Distance From Credit Impact Of COVID-19 Pandemic, published July 23, 2020), there is a notable dispersion in recovery between first-lien tranches issued by 'BB' and 'B' category rated entities, with the former having the largest bulk in the top-tier '1' recovery rating category (recovery of 90%-100%), while the latter is weighted toward the mid-tier '3' category (50%-70%).

Looking forward, we expect recovery estimates to experience more bouts of volatility, as the supply and demand dynamics of leveraged loans is still fragile given the uneven economic recovery, the uncertainty over future fiscal stimulus, and the U.S. election in November.

Chart 1

image

Breaking down by recovery rating by category, we expected about half of third-quarter new issues to recover 50%-70% in the event of a payment default, equating to a '3' recovery rating (chart 2). In contrast, '1' recovery ratings (indicating substantial recovery of 90%-100%), nearly halved in the third quarter, to 15% of total issuance, and they represented the largest quarter-over-quarter drop since 2014. A cross-time comparison with earlier defaults put this share notably below historical levels. Our recent study of U.S. corporates that emerged from bankruptcy since January 2008, "From Crisis To Crisis: A Lookback At Actual Recoveries And Recovery Ratings From The Great Recession To The Pandemic," published Oct. 8, 2020, reveals that 51% of first-lien debt recoveries were in fact in the 90%-100% recovery range, versus the 15% observed in the third quarter. This finding came from our review of bankruptcy documents including reorganization plans and disclosure statements. The decline of first-lien debt recoveries has become a source of tension, and we expect the default tally to rise well into 2021.

Chart 2

image

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Hanna Zhang, New York (1) 212-438-8288;
Hanna.Zhang@spglobal.com
Secondary Contacts:Olen Honeyman, New York (1) 212-438-4031;
olen.honeyman@spglobal.com
Robert E Schulz, CFA, New York (1) 212-438-7808;
robert.schulz@spglobal.com
Analytical Manager:Ramki Muthukrishnan, New York (1) 212-438-1384;
ramki.muthukrishnan@spglobal.com

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