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Leveraged Finance: U.S. Leveraged Finance Q1 2021 Update: As Issuers And Investors Collaborate To Keep Markets Active, Where Does The Excess Cash Go?


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Leveraged Finance: U.S. Leveraged Finance Q1 2021 Update: As Issuers And Investors Collaborate To Keep Markets Active, Where Does The Excess Cash Go?

The first quarter of 2021 was the busiest on record for both U.S. high-yield and institutional loan issuance, and this robust volume continued in April. This has fed yield-hungry investors' solid risk appetites, even though many companies are refinancing to reduce interest expenses and extend maturities. Riding the wave of market demand, there have also been some opportunistic dividend recapitalizations. The interest these issuances drew suggests that there is plenty of capital waiting to be deployed into the speculative-grade end of the market, even for issuers still experiencing severe financial stress.

Soaring Cash Balances Suggest Financial Flexibility, But Proactive Deleveraging Has Been Slow

Since the first wave of lockdowns more than a year ago, the pandemic has affected speculative-grade corporate borrowers' leverage and cash reserves. For this article, we've tracked the transition of median leverage (calculated as debt over EBITDA, as reported in companies' financial statements without adjustment by S&P Global Ratings) and cash balance (both in dollar amount and as a percentage of debt) for the 12-month periods ended between Sept. 30, 2019, and Dec. 31, 2020.

Description of data set: The sample consists of 971 companies. This is the majority of the speculative-grade industrial corporate entities that we rate in the U.S. and Canada, but it excludes those rated 'SD' or no longer rated as of April 21, 2021, either due to default or being withdrawn. The sample set is a subset of the 1,240 entities we used in our fourth-quarter 2020 report, as some companies hadn't yet reported their year-end financials by our cutoff date.

  • Median leverage peaked at 6.2x in the second quarter of 2020 before dipping over each of the subsequent quarters to 5.7x by year-end. Still, this measure remains well above its pre-pandemic level of 4.9x (see Chart 1).
  • There's been a buildup in cash (also see Chart 1). The median company in our sample carried $144 million of cash and short-term investments on its balance sheet as it entered 2021. This was almost double the amount outstanding at the end of third-quarter 2019 ($75.5 million) and was the highest level since 2019.
  • On the whole, cash balances and liquidity have been resilient throughout the pandemic. This could have taken some pressure off the rising leverage, as cash reserves could reduce the leverage ratio by up to a full turn, based on our calculation of net leverage ratio, which subtracts cash and marketable securities from debt principal outstanding. (In practice, we generally won't deduct accessible cash from debt if a company is owned by a financial sponsor or has a business risk profile assessment of weak.) However, this maximum-debt-reduction scenario is unlikely for reasons explained below.

Chart 1


  • Companies in our sample increased their cash-to-debt ratio by a median 6 percentage points to 14.2% over the last year (see Chart 2). The retreat in median debt principal outstanding has been modest, suggesting that the recent moderation in leverage was mostly fueled by EBITDA growth.
  • The rise in the cash-to-debt ratio indicates there's excess cash being held beyond what's needed for operation and debt service. However, record-tight credit spreads have reduced the opportunity cost of hoarding cash, and there's no pressing need to re-deploy cash or de-leverage. These factors suggest that companies might move slowly with debt unwinding.
  • Preserving financial flexibility is an important reason why. Most companies seem to be adopting cautious post-pandemic strategies. Having extra liquidity allows them to withstand future unexpected demand volatility or guard against market tightening. There are also competing uses for cash, such as M&A and leveraged buyouts, at a time when managerial focus is increasingly shifting from preserving liquidity toward funding growth and--to a lesser extent--shareholder payouts. The recent surge in M&A and the strong growth in dividend recap transactions demonstrate this trend. These decisions around financial policies will be a big factor in determining credit quality and the potential direction of rating actions.

Chart 2


  • Companies with ratings in the 'BB' category are doing better at restoring pre-crisis credit measures, cutting the leverage ratio by 0.2x-0.5x in the last quarter of 2020 (see Table 1). In comparison, it will take much longer for debt overhang to be absorbed in the lower credit tiers. The median leverage of entities rated 'B-' and lower reached a fresh high at the end of 2020, which doesn't bode well for their financial sustainability.
  • The 'CCC' category has had the largest deterioration, with median leverage now approaching the mid-teens. The gap between this segment and the higher-rated entities ('B-' and higher) has widened significantly.
  • Of the 16 sectors, leverage in 10 improved in the last quarter of 2020 versus the previous quarter, led by auto/trucks, chemicals, and forest product/building material/packaging (see Table 2). For auto/trucks, the LTM median ratio shrank to 5.7x from 7.7x over the second half of 2020, largely due to robust recovery in demand.
  • The transportation sector experienced the largest (more than four turns) year-over-year spike in leverage. This sector contains some of the companies hardest hit by the pandemic, such as airlines, the EBITDA of which turned negative for consecutive quarters. The media, entertainment, and leisure was also hit hard with leverage increasing by 3.3x. This sector contains companies severely affected by social-distancing measures, such as cruise operators, movie theaters, and hotels.
  • In contrast, the telecommunication, technology, and health care sector showed the greatest stability in terms of median LTM leverage. As such, the cumulative effect of the pandemic on their leverage is the least significant among the sectors, having increased by roughly only half-a-turn within our observation period.

Table 1

Median Leverage By Credit Rating
--Median leverage (x)--
Issuer credit rating as of April 21, 2021 Number of entities LTM Q3 2019 2019 LTM Q1 2020 LTM Q2 2020 LTM Q3 2020 2020
BB+ 98 3.2 3.2 3.5 3.6 3.5 3.2
BB 118 3.4 3.4 3.6 4.1 4.0 3.8
BB- 106 3.5 3.5 3.8 3.9 4.0 3.5
B+ 133 4.7 4.8 5.1 5.7 5.4 5.3
B 192 5.2 5.1 5.7 6.2 5.8 5.6
B- 205 7.6 7.4 8.0 8.8 8.4 8.4
CCC+ 91 7.5 7.6 9.7 12.2 13.7 13.4
CCC 19 7.7 8.3 9.9 15.2 14.9 11.8
CCC- 7 8.8 9.8 11.3 18.5 19.3 26.9
CC 2 10.6 9.6 9.0 10.9 12.9 15.4
Total 971 4.9 4.9 5.5 6.2 6.1 5.7
Debt and EBITDA are as reported in companies' financial statements without adjustment by S&P Global Ratings. LTM--Last 12 months. Source: S&P Global Ratings.

Table 2

Median Leverage By Industry
--Median leverage (x)--
Industry Number of entities LTM Q3 2019 2019 LTM Q1 2020 LTM Q2 2020 LTM Q3 2020 2020
Aerospace/defense 25 4.6 4.6 4.3 5.6 4.7 5.2
Auto/trucks 33 3.7 3.8 4.3 7.7 6.4 5.7
Business and consumer services 55 4.8 4.9 6.1 6.7 5.9 5.5
Capital goods/machinery and equipment 102 5.1 5.2 5.4 5.8 5.3 5.1
Chemicals 36 4.9 5.0 5.4 5.8 5.6 4.9
Consumer products 84 6.1 6.2 6.5 6.6 5.8 5.9
Forest products/building materials/packaging 39 4.4 4.6 4.7 4.0 3.8 3.3
Health care 73 6.9 6.6 7.1 6.7 6.6 6.6
Media, entertainment, and leisure 152 5.2 5.0 6.2 7.9 8.1 8.3
Mining and minerals 48 3.1 3.1 3.4 4.2 4.6 4.9
Oil and gas 68 2.5 2.9 3.0 4.3 5.3 5.1
Restaurants/retailing 72 3.7 3.9 4.1 6.5 5.4 5.0
Real estate 33 7.3 7.0 8.0 7.8 8.3 8.0
Technology 82 6.1 6.1 6.4 6.6 6.5 6.4
Telecommunications 44 4.8 4.9 4.9 5.0 4.7 4.5
Transportation 25 4.5 4.5 4.8 6.9 8.9 8.9
Total 971 4.9 4.9 5.5 6.2 6.1 5.7
Debt and EBITDA are as reported in companies' financial statements without adjustment by S&P Global Ratings. LTM--Last 12 months. Source: S&P Global Ratings.

Noteworthy Trends In First-Quarter 2021

Estimated recovery is on an upswing.  Capitalizing on the strong economic rebound, more companies are using cash to repay a portion of their pandemic-borrowing, thereby improving recovery prospects of the remaining debt outstanding. For example, semiconductor manufacturer MACOM Technology Solutions Holdings Inc. partially prepaid its senior secured term loan using balance-sheet cash and proceeds from an unsecured convertible notes issuance. This prompted us to revise the recovery rating on the remaining term loan and revolving credit facility to '1' from '3', reflecting the lower amount of secured debt and the sizable unsecured buffer now in the structure.

More than half of our changes to recovery assessments in the first quarter of 2021 were positive, meaning we either raised the recovery rating by at least one category or increased the recovery point estimate while keeping the rating unchanged. This marks a reversal from the previous quarter, when only about two-fifths of the movements were upward revisions.

Debt refinancing and topline growth have led to some upgrades from 'CCC+'.  Although we don't expect the share of risky credits to subside anytime soon, there has been some notable upgrade activity in the 'CCC' category. In particular, we upgraded several 'CCC+' rated entities to 'B-'. Their improved credit profiles largely stemmed from recent success in refinancing as well as stronger cash-flow generation due to returning demand and rising oil prices. This allowed them to perform better than we had previously expected. Del Monte Foods Inc. was among the latest to be upgraded to 'B-' from 'CCC+'. The rating action reflected the company's strong sales growth, primarily driven by demand for its portfolio of shelf-stable packaged vegetables and broths as U.S. consumers cooked more at home during the pandemic. In addition, the company is pivoting to an asset-light manufacturing model and has right-sized its cost structure. As a result, we no longer believe the company's capital structure is unsustainable.

This dynamic is unsurprising considering that the 'CCC' category (which comprises the 'CCC+', 'CCC', 'CCC-' ratings) generally tends to experience greater credit swings in either direction than the 'BB' or 'B' categories. That said, this development is of great importance to collateralized loan obligation (CLO) mangers because 'CCC' loans moving up to the 'B' category reduce the size of the portfolio's 'CCC' bucket and increases the O/C test cushions.

We see cost headwinds ahead.  In many cases, operating margins hinge on cost controls implemented during the pandemic's disruption, when companies cut their workforces or renegotiate supplier contracts. But this could reverse quickly once the crisis abates. Naturally, companies will need to rebuild working capital to get back to full operations or resume essential projects that were on hold or deferred during the pandemic. Exacerbating the costs is the continuing rally of labor, raw materials, and transport prices. As such, capital expenditures will ramp up despite still lagging the pace of revenue growth. With normalcy being gradually restored, it raises the question of whether such cost savings are permanent (such as exiting from unprofitable contracts and fleet optimization) or temporary (deferred rent or discretionary spending on travel and advertising). We make these assessments on a case-by-case basis in our projections.

First-Lien New-Issue Recovery Has Improved Marginally

Chart 3 illustrates the recovery trends of first-lien new issues, measured by the quarterly average of recovery estimates. As with everything else happened last year, 2020 was a year of extreme swings: Average recovery estimates peaked at 71% in the second quarter, when lenders became extremely selective, before hitting an all-time low of 62% at the end of 2020, when the first green shoots in the primary markets grew into a full bloom. The latest cohort of first-lien new issues inched closer to a return to its four-year average of 66%.

To understand the drivers behind the movements in new-issue recovery prospects, it helps to look at the mix of the borrower quality. There is a notable dispersion in recovery between first-lien tranches issued by entities with ratings in the 'BB' and 'B' categories. The former has the largest bulk in the top-tier '1' (90%-100%) recovery rating, while the latter is weighted toward a mid-tier '3' (50%-70%) recovery rating. The pandemic peak of 71% coincided with a surge of high-quality debt from 'BB' category entities, whereas based on the issue count, 51% of first-lien new issues were from this category. This share dropped to 11% in the subsequent quarters, alongside the slump of expected recovery. In contrast, 77% of new issues in the first quarter are from the riskier entities with ratings in the 'B' category.

While still low, the market now expects the interest rate to slowly pick up over the next few years. That means floating-rate instruments such as leveraged loans, which have already benefited from strong CLO formations, are becoming more attractive. This leads us to expect more receptiveness for deals with less-promising recovery and looser deal structures, because recovery prospects generally fluctuate along with shifts in investors' risk tolerance. That said, the magnitude of any quarterly swings of average recoveries will likely be modest.

Chart 3


By recovery rating category, we assigned a '3' recovery rating (meaningful recovery of 50%-70%) to a record 225 new issues in the first quarter, making up 60% of the total issuance (see Chart 4). Recovery ratings of '1' (very high recovery of 90-100%) and '2' (substantial recovery of 70-90%) grew the most, reaching a combined share of 32% in the first quarter from 22% one quarter ago. Despite the growth, this share is considerately lower than its long-term average. Our study of U.S. corporate debt recovery finds that about two-thirds of the first-lien debt of the companies that defaulted between January 2008 and June 2020 achieved 70%-plus recovery, which is significantly higher than the 32% in the first quarter.

Noteworthy among the new transactions was PetSmart LLC, which refinanced its capital structure, pushing out maturities and reducing total funded debt. We assigned a '1' recovery rating to the company's $2.3 billion term loan, which benefits from $4.0 billion of Chewy stock that the sponsor has pledged as collateral. Our recovery analysis considers the PetSmart enterprise value in combination with the anticipated value from Chewy equity, of which we took a significant (75%) haircut, as we expect its market value would fall drastically in a default scenario.

Chart 4


Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Hanna Zhang, New York + 1 (212) 438 8288;
Secondary Contacts:Robert E Schulz, CFA, New York + 1 (212) 438 7808;
Olen Honeyman, New York + 1 (212) 438 4031;
Analytical Manager:Ramki Muthukrishnan, New York + 1 (212) 438 1384;
Research Contributor:Maulik Shah, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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