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Default, Transition, and Recovery: U.S. Recovery Study: Clouds Loom As Defaults Rise

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Default, Transition, and Recovery: U.S. Recovery Study: Clouds Loom As Defaults Rise

The U.S. corporate speculative-grade default rate rose to 6.3% as of Oct. 31 as the COVID-19 pandemic, economic lockdowns, and a collapse in oil prices pressured companies. With defaults on the rise, investors are increasingly focused on potential recovery values. Despite increasing credit stress, recovery values in 2020 (through September) have remained in line with recent levels (see chart 1).

Chart 1

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In 2020, recoveries of term loans and revolving credit facilities that emerged from default averaged 64.2%, in line with the average of recent years, yet below the long-term average of 74%. Rising leverage, shrinking debt cushions, and the prevalence of covenant-lite instruments have weighed on recent loan recoveries, and we expect these factors to continue to challenge loan recoveries.

In 2020, bond recoveries held up at 44.8%, which is above the long-term average of 40%. In large part, these recent bond and note recoveries have been boosted by the prevalence of distressed exchanges, as bonds tend to recover more through a distressed exchange than through a bankruptcy restructuring.

Recoveries in 2020 are in line with average recoveries since the beginning of 2018. First-lien term loan recoveries have been lower than pre-2018 levels, while bond recoveries have been higher for senior secured, senior unsecured, and subordinated bonds (see chart 2).

Chart 2

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We based our analysis for this study on data from S&P Global's LossStats®, which is available through S&P Global Market Intelligence's CreditPro® and contains ultimate recovery values for 4,340 defaulted instruments from over 1,100 U.S. issuers that emerged from default between 1987 and September 2020. Except where noted, recovery values we cite refer to the discounted recovery, where the discount rate applied is the instrument's effective interest rate.

This approach differs from that of S&P Global Ratings' recovery ratings methodology (and recovery studies based on our methodology). S&P Global Ratings' recovery ratings indicate expected recovery prospects, calculated on a nominal basis, based on a future hypothetical default scenario. For more details on the approach used for each, please see the Definitions section.

Why Are Loan Recoveries Below Their Long-Term Average?

First-lien term loan recoveries have fallen in recent years, following a buildup in leverage, a shrinking of subordinated debt cushions, and a growing proportion of loans that are covenant-lite. We expect that these factors will continue to contribute to generally lower recoveries.

Leverage Is Rising In New Loan Issues

Leverage has been rising for newly issued loans, and much of the increase has been concentrated in senior debt. According to S&P Global Market Intelligence's Leveraged Commentary & Data, debt to EBITDA for newly issued first-lien term loans from large corporate issuers rose to 4.24x EBITDA in 2019 from 3.24x in 2011, when financing conditions in the loan market were tighter in the aftermath of the global financial crisis. In the first half of 2020, leverage declined for new issues as investor risk aversion escalated in response to the COVID-19 pandemic. However, leverage rebounded in the third quarter of 2020, climbing to 4.5x EBITDA (see chart 3).

Chart 3

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Debt Cushions Are Shrinking

With more debt concentrated at the top of the debt stack, debt cushions have eroded. First-lien term loans tend to show higher recoveries when they have a larger cushion of subordinated debt in the debt structure. Historically, first-lien term loans with a debt cushion of 75% or more of the debt structure have averaged nearly a 90% recovery (see chart 4).

None of the first-lien term loans in our dataset that have emerged from default in the past two years have had debt cushions as large as 75% of the debt structure. Most have had debt cushions of just 25% (or less), and this has weighed on recent loan recoveries. Nearly three-fourths of first-lien loans that have emerged in recent years had a debt cushion of less than 25%.

Chart 4

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Most New Loans Are Covenant-Lite

Few newly issued term loans include financial maintenance covenants. These covenant-lite loans account for more than 80% of new institutional first-lien term loans issued since 2018 (see chart 5). This proportion remained steady in 2020 even as the volume of new loans declined. Data suggests that these recent covenant-lite first-lien loans have lower recoveries than non-covenant-lite loans.

Chart 5

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Our recovery dataset includes a small sample of 42 covenant-lite first-lien term loans that defaulted between 2002 and 2020. For the instruments that defaulted in 2010 and after, covenant-lite loans have shown lower recoveries than non-covenant-lite loans. Among first-lien term loans that defaulted since 2010, those that were covenant-lite have averaged a 57.4% recovery, and this is 16 percentage points less than the average recovery of non-covenant-lite first-lien loans over the same period (see chart 6).

Chart 6

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We expect that recoveries for first-lien term loans will face challenges, as new first-lien term loan issuance continues to exhibit rising leverage, shrinking debt cushions, and absence of financial maintenance covenants, factors that are included in our recovery rating analysis.

Based on the recovery ratings assigned to senior secured first-lien instruments in North America during the third quarter, S&P Global Ratings Leveraged Finance team projects an average recovery estimate of 65% (on a nominal basis). While this is down from the estimated recovery rates for loans issued in the second quarter, the current projection is in line with projections from recent years (see "U.S. Leveraged Finance Q3 2020 Update: Pandemic-Induced Borrowing Dilutes Recovery Prospects And Lessens Interest Coverage," published Nov. 2, 2020).

Bonds Continue To Show Elevated Recoveries Following Distressed Exchanges

Bonds and notes have experienced above-average recoveries in recent years, and recoveries of these instruments have been boosted by the prevalence of distressed exchanges.

Distressed exchanges account for more than 60% of the bonds in our dataset that have emerged from default since 2018. Non-bankruptcy restructurings such as these tend to result in higher bond recoveries than those that follow a Chapter 11 bankruptcy.

For bonds that emerged from defaults in this recent period (see chart 7):

  • Senior secured bonds have averaged a 75% recovery following a distressed exchange (22 percentage points higher than the average bankruptcy restructuring over the same period), and
  • Senior unsecured bonds have averaged a 67% recovery following a distressed exchange (more than 50 percentage points higher than the average bankruptcy restructuring over the same period).

Chart 7

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Post-bankruptcy recoveries from unsecured bonds have fallen well below long-term averages in recent years. With leverage rising, and increasingly concentrated in the most senior debt classes, unsecured bondholders may find their recovery prospects diminishing if faced with an uptick in bankruptcies.

Recovery By Instrument Type

Among instrument types, debt instruments that are more senior tend to exhibit higher recoveries with lower variance than more junior debt. Historically, revolvers show the highest recoveries, with a mean recovery of 79.3% and a median recovery of 95.2%. First-lien term loans follow with a mean recovery of 71.7% and a median of 80.9%. Recoveries fall considerably for second-lien (and unsecured) term loans, with an average recovery 44% and a median of 29.9%. These second-lien (and unsecured) term loans show the highest standard deviation of 40.7% and often display a bimodal recovery distribution that is either fully paid or not paid at all.

Bonds overall have lower average recoveries than loans, though recoveries vary widely by bond type. Senior secured bonds have the highest mean recovery, at 55.9% (median of 57.7%), and senior unsecured bonds have a mean recovery of 44.9% (see table 1).

As subordinated debt typically accounts for a small share of the firm's debt structure, there is often no value left to provide recoveries for these instruments in a bankruptcy after the senior debt holders are paid. Subordinated bonds show a modal recovery value of zero, even as average recoveries are higher. Senior subordinated bonds show an average recovery of 29.9%, while non-senior subordinated bonds show an average recovery of 22.6%.

Table 1

Recovery Rates By Instrument Type (1987-2020*)
Instrument type Mean (%) Median (%) Dollar weighted rate (%) Standard deviation Coefficient of variation (%) Count
Discounted recovery
Revolving credit 79.3 95.2 68.6 28.5 35.9 766
Term loans (first lien) 71.7 80.9 70.7 29.7 41.4 730
Term loans (second lien and unsecured) 44.1 29.9 53.5 40.7 92.4 99
All loans/revolvers 73.6 88.1 69.1 31.1 42.2 1,595
Senior secured bonds 55.9 57.7 54.5 32.0 57.3 376
Senior unsecured bonds 44.9 42.1 42.2 32.4 72.2 1,347
Senior subordinated bonds 29.9 18.1 28.6 32.1 107.4 551
All other subordinated bonds 22.6 9.2 25.8 29.5 130.5 471
All bonds 39.6 31.0 40.3 33.6 84.9 2,745
Total defaulted instruments 52.1 51.7 50.6 36.6 70.3 4,340
Nominal recovery
Revolving credit 88.6 100.0 77.7 33.0 37.3 766
Term loans (first lien) 80.3 93.9 76.5 34.9 43.5 730
Term loans (second lien and unsecured) 50.8 37.1 59.6 47.4 93.3 99
All loans/revolvers 82.5 100.0 76.2 36.1 43.7 1,595
Senior secured bonds 66.9 69.5 63.4 39.1 58.5 376
Senior unsecured bonds 52.3 49.5 47.5 38.7 73.9 1,347
Senior subordinated bonds 35.2 20.8 33.6 37.4 106.4 551
All other subordinated bonds 28.2 10.9 31.8 37.6 133.4 471
All bonds 46.7 36.5 46.1 40.3 86.2 2,745
Total defaulted instruments 59.9 60.4 56.8 42.5 70.9 4,340
Note: Includes only debt instruments that defaulted from U.S. issuers. *Data through September 2020. Sources: S&P Global Market Intelligence's CreditPro® and S&P Global Ratings Research.

On a nominal basis, where the ultimate recovery value has not been discounted to account for the time between default and emergence, recoveries across the debt structure are notably higher: Loan and revolver recoveries average 82.5% while bond and note recoveries average 46.7%.

In addition to these issue-weighted recovery values, we also include recoveries on a dollar-weighted basis for both the discounted and the nominal rates in table 1. For these dollar-weighted recoveries, we calculate the discounted (or nominal) sum of debt recovered and divide it by the total amount of defaulted debt in the sample for that instrument type.

Instruments with lower seniority tend to have a wider variety of average recoveries than higher-priority instruments. The coefficient of variation, or the standard deviation scaled by the mean, rises for instruments lower in the capital structure. While the coefficient of variation for loans and revolvers is 42%, it rises to 85% for bonds overall.

Over Half Of Recent Recoveries Are From The Oil and Retail Sectors

By sector, the largest share of emergences from 2018 through third-quarter 2020 has come from oil and gas, followed by retail and restaurants. Together, these sectors account for just over half of the instruments for which we have observed recoveries over this period (see chart 8).

Chart 8

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In the oil and gas sector, loan recoveries have averaged 70%. While this is below the long-term average recovery for loans in the sector, these loan recoveries are higher than the overall average loan recovery rate across sectors over this period (see table 2). Oil and gas sector loans were largely backed by first-lien collateral of oil and gas assets, and this collateral helped to support recoveries. Bond recoveries in the oil and gas sector remain above the sector's long-term average, and most of these defaults were distressed exchanges.

In the retail and restaurant sector, both loan and bond recoveries held up above the sector's long-term average. Bond recoveries were supported by the prevalence of distressed exchanges among the defaults.

Table 2

Average Recovery By Nonfinancial Sector
Sector All instruments (recovery, %) Loans (recovery, %) Bonds (recovery, %) Loans (count) Bonds (count)
Aerospace and defense 46.0 77.2 29.3 16 30
Automotive 50.4 79.3 32.0 87 137
Capital goods 48.8 64.3 36.5 100 126
Chemicals, packaging, and environmental services 51.8 64.3 39.9 89 93
Consumer products 57.8 76.2 39.8 190 194
Forest products and building materials 58.8 76.2 44.2 85 101
Health care 52.9 70.1 37.1 90 98
High technology 51.9 71.6 36.0 93 115
Homebuilders/real estate companies 41.4 81.0 30.8 19 71
Media and entertainment 52.0 73.3 38.1 171 261
Metals, mining, and steel 52.8 85.6 33.6 56 96
Oil and gas 53.7 79.7 45.0 89 266
Retail/restaurants 49.9 72.9 33.0 246 337
Telecommunications 40.5 70.9 29.7 144 407
Transportation 55.7 80.8 45.9 54 138
Utility 73.3 70.6 74.0 46 161
Note: For bonds and loans that defaulted from U.S. issuers. Sources: S&P Global Market Intelligence's CreditPro® and S&P Global Ratings Research.

Across all sectors, we see the highest average recoveries for debt secured by inventories or receivables, which averages a 90.9% recovery with a lower standard deviation than that of the other collateral types. Debt secured by a second or third lien showed lower recoveries (see table 3).

Table 3

Average Discounted Recovery By Collateral Type
Collateral type Mean recovery (%) Standard deviation Dollar weighted rate (%) Count
All (or most) assets 73.5 30.3 67.1 1,152
Inventories/receivables 90.9 19.4 88.9 107
Other 70.1 28.4 68.2 161
PP&E 65.4 31.7 74.0 308
Second lien (and below) 46.9 37.1 40.4 163
Unsecured 37.8 33.5 39.3 2,449
Note: For bonds and loans that defaulted from U.S. issuers. PP&E--Property, plant, and equipment. Sources: S&P Global Market Intelligence's CreditPro® and S&P Global Ratings Research.

Loans From Middle-Market Companies Tend To Recover More Than Those From Larger Entities

Historically, term loans and revolvers from small or middle-market companies (those with $350 million or less in debt outstanding at the time of default) have tended to show modestly higher recovery rates than those from larger companies.

The same is true for loans and revolvers that have emerged from default since 2018. Bonds of middle-market companies, by contrast, tend to show lower average recoveries than those of larger entities (chart 9).

Chart 9

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A typical middle-market debt structure often consists of a revolving credit facility, a term loan, and a senior secured bond. By contrast, larger companies often have more varied and complex capital structures. Loans and revolvers of middle-market companies tend to exhibit higher recoveries than those of larger entities. However, bonds and notes from middle-market companies show lower recoveries (on average) than those from larger companies. In large part, this reflects a higher concentration of subordinated bonds among the middle-market debt structures.

By instrument type, recovery rates for middle-market first-lien term loans averaged 77.7% on a discounted basis since 1987, which is higher than 68.2% average recovery for first-lien term loans from larger corporates (see table 4).

Table 4

Recovery Rates By Instrument Type (Middle Market Versus Larger Firms, 1987-2020*)
--Middle-market firms-- --Larger firms--
Instrument type Mean (%) Median (%) Dollar-weighted rate (%) Count Mean (%) Median (%) Dollar-weighted rate (%) Count
Discounted recovery
Revolving credit 85.3 99.7 83.3 362 73.8 86.6 66.4 404
Term loans (first-lien) 77.7 89.3 71.0 266 68.2 74.3 70.6 464
Term loans (second-lien and unsecured) 46.4 29.9 37.4 37 42.7 31.2 55.5 62
All loans/revolvers 80.1 96.7 75.4 665 68.9 78.0 68.4 930
Senior secured bonds 50.2 44.1 47.3 150 59.7 67.3 56.2 226
Senior unsecured bonds 48.0 42.9 41.1 259 44.1 41.9 42.2 1,088
Subordinated bonds 29.3 16.4 31.6 455 24.3 12.6 26.6 567
All bonds/notes 38.6 30.2 38.5 864 40.0 31.4 40.5 1,881
Total defaulted instruments 56.6 59.2 50.4 1,529 49.6 49.3 50.6 2,811
Nominal recovery
Revolving credit 95.1 101.1 92.8 362 82.9 99.1 75.5 404
Term loans (first-lien) 87.9 100.0 80.0 266 76.0 81.4 76.3 464
Term loans (second-lien and unsecured) 55.8 32.6 41.9 37 47.8 37.2 61.9 62
All bank debt 90.0 100.0 84.4 665 77.1 90.0 75.3 930
Senior secured bonds 60.2 53.5 56.0 150 71.4 81.9 65.1 226
Senior unsecured bonds 57.0 52.0 47.6 259 51.2 48.2 47.4 1,088
Subordinated bonds 35.9 19.6 38.1 455 28.8 15.0 31.7 567
All bonds/notes 46.4 36.5 45.6 864 46.9 36.5 46.2 1,881
Total defaulted instruments 65.4 69.5 58.1 1,529 56.9 56.0 56.7 2,811
Note: Includes only debt instruments that defaulted from U.S. issuers. "Middle-market firms" defined as firms with $350 million or less in total debt outstanding at the time of default. *Data through September 2020. Sources: S&P Global Market Intelligence's CreditPro® and S&P Global Ratings Research.

The Distribution Of Recoveries Varies By Instrument

Given their seniority in the debt structure, term loans and revolving credit facilities tend to show higher recoveries than bonds and notes. For loans and revolvers, recoveries of par or greater occur much more often than for bonds or notes. Most defaulted loans and revolvers experienced elevated recoveries of 80% or higher, and nearly 27% of loans and revolvers recovered at par or greater (see chart 10).

Chart 10

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Alternatively, when we take all of first-lien debt, including first-lien senior secured bonds along with first-lien revolving credit facilities and term loans, more than half of the defaulted instruments recovered 80% or more. 25% of first-lien instruments recovered par or greater.

Chart 11

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On the other hand, the distribution of bond and note recoveries skews lower. Less than 5% of defaulted bonds and notes have recoveries at par or greater, while 27% of defaulting bonds and notes experienced negligible recoveries of 10% or less (see chart 10).

Chart 12

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Definitions

We define recoveries as the ultimate recovery rates following emergence from three types of default: bankruptcy filings, distressed exchanges, and nonbankruptcy restructurings. Unless specified otherwise, we base recoveries at the instrument level, and we discount them by using each instrument's effective interest rate. Instruments that did not default are excluded from this study.

In the S&P Global LossStats® database, the coupon rate at the time the last coupon was paid is the effective interest rate used for the discount factor. We calculated the discounted recovery values by discounting instruments or cash received in the final settlement on the valuation date back to the last date that a cash payment was made on the prepetition instrument. The last cash pay date represents the true starting point for the interest accrual, which is why we use this date as the starting point for the discounting, rather than the default date of the instrument or the bankruptcy date of the company. For fixed-coupon instruments, this is the fixed rate, and for floating-rate instruments, it is the floating rate used at the time of default. Nominal recovery rates, which are the nondiscounted values received at settlement, are also reported.

We prefer discounted rates in this study because they allow us to better compare bankruptcies of different lengths. For example, the nominal rate on a distressed exchange could be the same as that on a bankruptcy case that takes two years. However, investors in the bankruptcy case are significantly worse off because they could lose significant time value while waiting for the final settlement. On the other hand, a distressed exchange could take only a day. In a historical study, discounted recovery rates offer the major benefit of making different periods more comparable by preventing any major bias that could arise if times between default and emergence differed greatly. S&P Global Ratings provides recovery ratings that map to nominal values.

Recovery is the value creditors receive on defaulted debt. Companies that have defaulted and moved into bankruptcy will usually either emerge from the bankruptcy or be liquidated. On emergence from bankruptcy, creditors often receive a cash settlement, new instruments (possibly debt or equity), assets or proceeds from the sale of assets, or some combination of these.

Ultimate recovery

Ultimate recovery is the value of the settlement a lender receives by holding an instrument through its emergence from default. The recovery is based on the amount received in the settlement divided by the principal default amount. Within the S&P Global LossStats® database, three recovery valuation methods are used to calculate ultimate recovery:

Trading price at emergence.  We can determine the recovery value of an instrument by using the trading price or market value of the prepetition debt instruments upon emergence from bankruptcy. Of the three valuation methods, this one is the most readily available because most debt instruments continue to trade during bankruptcy proceedings. This approach differs from the commonly used "30-days after default" method, which measures recovery estimates shortly after default, rather than at emergence.

Settlement pricing.  The settlement pricing includes the earliest public market values of the new instruments that a debtholder receives in exchange for the prepetition instruments. This method is similar to the trading price method, except that it is applied to the new (settlement) instrument instead of the old (prepetition) instrument.

Liquidity-event pricing.  The liquidity event price is the final cash value of the new instruments or cash from the sale of assets that the lender acquires in exchange for the prepetition instrument.

Comparison With Recovery Ratings

This approach we use for assessing recovery is different from how S&P Global Ratings determines its recovery ratings. S&P Global Ratings' recovery ratings are estimates of recovery for debt instruments from entities rated speculative grade ('BB+' or lower). These recovery ratings indicate expected recovery prospects, calculated on a nominal basis, based on a future hypothetical default scenario and reflecting the expected recovery following an entity's emergence from bankruptcy via a going concern or liquidation. These recovery ratings are issue-specific and range from '1+' (high expectations for a full [100%] recovery) to '6' (0%-10% recovery).

The approach to determining recovery values that we use in this report also differs from the study "From Crisis To Crisis: A Lookback At Actual Recoveries And Recovery Ratings From The Great Recession To The Pandemic," published Oct. 8, 2020. That study excluded recoveries following distressed exchanges, and it used the implied recoveries from the bankruptcy plans as the basis for the value received, rather than trading prices, as the bankruptcy plan information was more consistently available for the issuers included in the study. In addition, the study only covers companies going through U.S. bankruptcy and uses actual recovery estimates on a nominal versus discounted basis.

Related Research

This report does not constitute a rating action.

Ratings Performance Analytics:Nick W Kraemer, FRM, New York + 1 (212) 438 1698;
nick.kraemer@spglobal.com
Evan M Gunter, New York + 1 (212) 438 6412;
evan.gunter@spglobal.com
Research Contributor:Abhik Debnath, CRISIL Global Analytical Center, an S&P Global Ratings affiliate, Mumbai

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