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European Leveraged Finance Q2 2022: It's Not The Fall That Kills You


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European Leveraged Finance Q2 2022: It's Not The Fall That Kills You

Investors appear to lack confidence in the European Central Bank's inflation narrative amid mounting challenges to economic growth. Credit spreads have widened to near pandemic-levels, swinging wildly from week to week. European equity indices were down by an average 20% over the first six months of the year. Volatility in both markets was fueled by fears that monetary policy will be ineffective in staving off high inflation and mounting recession risks, energy supply shocks and food supply disruptions.

In this context, leveraged loan and bond issuance shrunk to just €43.2 billion in the first half (H1) of this year compared to €160 billion in H1 2021. Transactions have taken longer to complete, while some have failed to launch altogether, despite having been closed and funded. This has created a backlog of debt issuance with uncertain prospects for placement. Underwriting banks have adjusted by changing the debt capital structures of debt packages on offer, adding amortizing loan tranches held by their risk departments. They have also taken considerable losses by offering discounts to par on the debt offered in the mid-80 cents to the euro in order to clear transactions as the secondary market gap widened.

As CLO issuance--usually the engine behind leveraged loan primary issuance--has dried up and monthly credit fund losses have widened, underwriting banks are increasingly seeking placement for new loans through off-market deals. Since April, debt issuance has increasingly relied on extensive pre-marketing, while completion has often hinged on a handful of cornerstone investors filling order books. Several transactions, notably Morrisons--via parent company Market Bidco--and, more recently, 888 Holdings, have struggled to fully syndicate their debt, despite extensive pre-marketing.

Widening credit spreads, at levels akin to the subprime mortgage crisis of 2008 and the sovereign debt crisis of 2012, have made private lending, which was typically offered at yields of 7%-8%, more palatable, particularly if speed to completion and high leverage are factors in a transaction. Direct lending funds, which have had limited opportunity to deploy plentiful cash, have relaxed covenant and pricing terms to attract deals. However, this may only be a temporary opportunity for issuers, as being beholden to a limited number of creditors has its disadvantages, making wider syndication ultimately more preferable.

Speculative-grade corporate ratings ('BB+' and below) are holding up so far, thanks to strong performance in 2021 and continuing consumer demand. However, rising input costs and sharply rising financing may drag on ratings in the latter half of 2022. We think issuers should be able to absorb a mild downturn. But in our scenario analysis of a full recession leading to a 20% decline in EBITDA in 2023 (not our base case), ratings would likely come under pressure, particularly those in the single 'B' category and below. Such a recessionary scenario may aggravate investor fears that "it's not the fall that kills you, but the sudden stop at the end".

A Steep Fall In New Issuance

Amid investor uncertainty, new issuance of speculative-grade first-lien debt fell by 73% in H1 2021 on the same period of last year (see chart 1). Loan new issuance was down 66% for the same period, to €28 billion from €83 billion, the lowest for any six-month period since 2012. Bond issuance fell even more steeply by 80% for the same period, to a mere €15 billion from €77 billion in H1 2021, the lowest since the 2008 global financial crisis.

Chart 1


The deterioration in investor sentiment was more pronounced in the second quarter, when monetary policy uncertainty was compounded by persistently record high inflation and increasing fears of recession. The S&P European Leveraged Loan Index, indicating the average bid price of high-flow liquid loan tranches, declined 10 points since April, to 89 by the last full week in June. Falling secondary loan prices caused turmoil that affected some transactions. The 'B' rating category credit spread widened more than 3% on average. Certain credits such as Morrisons and 888, and sectors such as real estate and consumer, saw risk premiums widen by more than 5%.

Issuers that investors consider most likely to resist an economic downturn, predominantly in the health-care sector, dominated new issuance with broad syndication that occurred over the first half of 2022. The issuance was marked by delays and widening prices over the marketing period. Inovie Group, a French laboratory operator, priced a €400 million add-on loan to fund M&A at a Euribor plus 500 basis points (bps) with 0% floor, after the original issue discount (OID) widened to 94 cents on the euro from 96-97 cents. The transaction took over two weeks. OptiGroup, a Swedish B2B paper products distributor, pulled its €515 million loan offer after its initial price offering of Euribor + 515 bps with an OID of 95 did not find traction with investors. The lack of appetite in traditional syndication and placement channels has created opportunities for direct lenders to act as underwriters in sponsor-led transactions, such as CD&R's acquisition of Atalian.

We expect secondary market volatility and subdued primary volumes to continue into the second half of the year, despite healthy pipelines. The ECB's July rate rise surprised markets, and they have reacted positively. However, it is too soon to call it a full recovery.

Driven in part by fewer bond transactions, the average expected recovery rate for newly rated first-lien debt was slightly higher in the second quarter (Q2) 2022 at 62% (see chart 2). Another driver of this rise was the higher number of new ratings that incorporate subordinated debt.

Chart 2


Table 1

Rated First-Lien New Issuance, By Rating Category And Type Of Debt
H1 2022 average estimated recovery
Average recovery (%)
Loans (excl. RCF) Senior secured notes All issuance
'B' category rated tranches 60 56 59
'BB' category rated tranches 63 83 77
H--Half. RCF--Revolving credit facility. Source: S&P Global Ratings.

Recoveries On All Rated First-Lien Debt Are Up Slightly

The average recovery rate on outstanding rated debt improved marginally in Q2 due to a higher contribution of debt with expected recovery at hypothetical default of 60% and 65% (see chart 3).

As of June 30, 2022, we rated €889 billion equivalent of speculative-grade debt from 770 unique European obligors. We rated €630 billion equivalent of outstanding senior secured debt, including loans, bonds, and committed revolving credit facilities (RCFs) from 608 first-lien senior secured debt obligors. The average estimated recovery rate for all rated first-lien secured facilities improved marginally to 58% over the first two quarters of 2022 (see chart 3).

Chart 3


Our expected recovery rate remains on average much lower than the realized average first-lien recovery rate of 72.5% over 2003-2021 (see "European Corporate Recoveries 2003-2021: Stability Prevails Despite The Pandemic," published May 31, 2022, on RatingsDirect).

Recovery prospects differ widely by sector. Telecommunications issuers remain the largest contributors to rated European speculative-grade senior secured debt, with a dozen or so prolific issuers both in the loan and bond space, such as Altice International, Telenet Group Holding, UPC Holding, Ziggo, and Virgin Media Finance (see chart 4).

Chart 4


A recovery rating of '3', indicating our expectation of a recovery rate of 50%-70%, remains the most common recovery rating for first-lien speculative-grade debt in Europe. Within the recovery rating category of '3', expected rounded recoveries of 50% or 55% account for 36% of the total senior secured rated debt, while expected recoveries of 60% or 65% constitute 46% of the total (see chart 5).

Chart 5


New senior secured debt contribution was highest in the 60% and 65% recovery bucket (or 66% of total additional debt) over the first half of 2022. About 14% of the total new senior secured debt had a recovery rating of 50%-55% over the same period, and about 9% of all additional tranches were in recovery rating category '2', with expected recoveries of 70%-90%.

Expected recoveries for loans continue to be higher than for bonds

Senior secured loans, on average, have higher expected recovery rates than bonds irrespective of the rating (see table 2). Bond-only capital structures yield lower expected recoveries due to their broadly higher opening senior secured leverage and the presence of super senior RCF, which we treat as priority debt and assume to be 85% drawn at time of default.

Table 2

Rated European First-Lien Debt Recovery, By Rating Category And Type Of Debt
As at June 30, 2022, by value and average estimated recovery
'CCC+ or below' rated tranches* 'B' category rated tranches 'BB' category rated tranches
Amount outstanding (Bil. €) Average recovery (%) Amount outstanding (Bil. €) Average recovery (%) Amount outstanding (Bil. €) Average recovery (%)
Loans (excl. RCF) 19.8 51 307.7 57 91.6 63
Bonds 8 49 122.4 54 50.4 63
Total 29.2 51 452.1 57 148 64
*Excluding 'CC' and 'D/SD'. RCF--Revolving credit facility. Source: S&P Global Ratings.

Credit Quality Is Stable, With Fewer Weakest Links And Defaults

Underpinned by strong performance in 2021 and continued consumer demand, the first half of 2022 saw more upgrades than downgrades and a continued trend toward stabilization across the rating spectrum, particularly among 'B' category rated issuers. The pace of upgrades paused briefly in March, following the start of the Russia-Ukraine conflict, but soon resumed on the back of strong year-end and first-quarter results, particularly in sectors that had been heavily impacted by the pandemic (see chart 6).

Chart 6


Strong demand growth in 2021, and the rapid and successful passing on of input cost increases, led to credit metric improvements, increased cash balances, and net positive rating actions over the first five months of 2022 (see "Credit Conditions Europe Q3 2022: Pain On The Horizon," published June 28, 2022). Still, recession risk remains the key threat for European noninvestment-grade issuers, as high inflation impacts virtually all sectors (see "Lights Dimming, European Corporate Credit Outlook, Midyear 2022," published July 28, 2022).

Some sectors showed initial signs of EBITDA margin weakness during the first quarter. This remains concentrated in industries subject to energy price volatility (utilities, chemicals and building materials), consumer confidence weakness (consumer products, food-related paper and packaging), and economic growth jitters (business services, real estate; see "Credit Conditions Europe Q3 2022: Pain On The Horizon," published June 28, 2022). High-level sensitivity analysis suggests issuers will prove relatively resilient to downgrades in a mild recessionary scenario. However, a deeper recession in 2023 would likely lead to far greater downward pressure on ratings, particularly in the lower end of the 'B' rating category.

The credit quality of first-lien secured debt continued to improve in first-half 2022 (see chart 7). This was mainly due to rating upgrades and, to a smaller extent, new issues.

Chart 7


Only three defaults, excluding Europe-based entities with solely Russian operations   Owl Finance, Promotora de Informaciones (Prisa), and Safari Beteiligung were downgraded to 'CC' to reflect proposed debt restructurings, and were subsequently downgraded to 'SD' when the transactions completed.

Seven additional issuers were downgraded to 'CCC' and below, including Frigoglass Finance, Schur Flexibles, Raven Property Group, SAS AB, and Adler Group. In July, we also downgraded SAS AB to 'D' after it filed for Chapter 11 protection and Vue to 'CC' on the back of announced restructuring.

Our base-case expectation is that the 12-month trailing European speculative-grade default rate will reach 3%, or 24 issuers, by March 2023 (see "The European Speculative-Grade Corporate Default Rate Could Rise To 3% By March 2023," published May 18, 2022). However, the default tally could overshoot that forecast if pressure on profits mounts further, or if issuers fail to refinance debt in a timely manner due to unreceptive and expensive debt primary markets.

'B' Ratings Would Suffer In A Deep Recession, Our Stress Test Shows

While a recession is not our current base case, we have revised downward our GDP forecasts for key geographies because record high inflation and rising interest rates dominate our credit risk considerations. To better understand the possible effects of the increased downside credit risks, we simulated three hypothetical downturn scenarios across all rated issuers in the European nonfinancial speculative-grade universe (see also "Recession Risk And Ratings: What Recession Could Mean For European Speculative Grade Nonfinancial Corporates," published June 23, 2022). The three scenarios, applied to S&P Global Ratings' base-case estimates for 2022 and 2023, envisage the following:

  • A mid-cycle dip where year-on-year EBITDA growth weakens this year but remains positive at 11% (versus 16% in the base case), before declining 4% in 2023. Cash interest charges rise by 1%.
  • A mild recession, where EBITDA growth weakens considerably but remains positive this year at 5.5%, before a more substantial decline of nearly 9% in 2023. Cash interest charges rise by 1.5%.
  • A full recession, where EBITDA growth is flat this year and declines sharply by 20% in 2023 (versus 2021), mimicking historical earnings decreases. Cash interest charges rise by 1.5%.

The degree of stress applied is tailored to reflect industry volatility and individual company risk scores, and we made certain qualitative adjustments to reflect prevailing circumstances in certain sectors.

Issuers should be able to absorb milder downturns

In the first two scenarios, speculative-grade median leverage metrics (as measured by debt to EBITDA) would deteriorate, but not beyond the levels seen during the pandemic. Multiple-notch downgrades and conventional defaults would also be sparse due to robust 2021 performance, solid cash balances across the rating spectrum, and flexibility provided by unused portions of revolving credit facilities. Maturity wall pressures are low across the credit rating spectrum, at least until 2024, allowing issuers flexibility to address operating and financing pressures over a longer period of time. Exceptions to this could come from the most vulnerable issuers in the 'CCC' category and issuers that struggle to refinance their 2023 maturities due to market dislocation.

A recession would bring downgrades

A full recession would likely deliver considerably negative rating pressures, with median leverage metrics weakening to 7.8x, versus the pandemic peak of 6.6x and 5.3x currently expected in our base case. The number of issuers with negative free operating cash flow (FOCF) generation as a percentage of debt are forecast to nearly double in our full recession scenario, rising to 50% of all issuers in the simulation, compared with 17%-28% in the milder downturn scenarios (see charts 8 and 9).

Chart 8


Chart 9


Within the 'B' rating category, a recession would pile on progressive stress

'B+'.   Negative rating pressure for issuers rated 'B+' should be limited to issuers that are unable to curb capex expenditure, that suffer supply-chain lag and inventory build-up, and are exposed to energy supply risk or falling end-market demand. Median leverage is not expected to increase beyond 7x in the most severe scenario. However, more than one-half of the entities will have negative cash flow, suggesting a greater probability for negative outlooks rather than downgrades. Issuers that have limited headroom would be the exception. Issuers in this rating category have a median cash-to-debt ratio of 16% (not accounting for RCF that are largely undrawn, particularly by asset-light corporates), thereby indicating generally good liquidity that could absorb reduced FOCF.

'B'.  'B' rated issuers are well positioned to weather the milder downturn scenarios because median leverage is not expected to rise beyond 7x and issuers with negative FOCF would account for less than 20% of the total. Downgrades would probably be triggered by those with currently limited cash flow generation, smaller cash buffers, and elevated leverage levels. A full recession would trigger significant negative rating pressure, as median leverage would likely increase to 8x, while nearly 40% of all issuers would have negative free operating cash flow in 2023. Issuers with nimble cost structures, the ability to swiftly address capex expenditures, and limited inventory risk should be best placed.

'B-'.  'B-' rated issuers appear the most vulnerable and susceptible to negative rating actions within the 'B' rating category, particularly in a full recession scenario. The most severe downturn would result in median leverage of about 10x (see chart 10), which is typical for a 'CCC' rating category. Furthermore, issuers with negative FOCF to debt would increase sixfold, to more than one-third of the population. It is likely that that liquidity would be strained by the six to nine quarters of negative free cash flow (as modelled). Refinancing risk compounds the downward rating pressure for 'B-' issuers.

Chart 10


Sectors most resilient to a full recession scenario include oil and gas, metals and mining, telecommunications, and health care

In a full recession, most sectors would see elevated median leverage levels above 7x. The exceptions are those where we applied qualitative adjustments to reflect tailwinds that are expected to prevail until the end of 2023--oil and gas, metals and mining, telecommunications, engineering and construction, and transportation. Engineering and construction companies, for example, have typically been vulnerable to recessionary forces, but are currently protected by staff shortages and strong demand. That should enable them to spread bulging orderbooks over several quarters and offset negative effects of a downturn. Transportation issuers within these rating categories are airlines, which are benefitting from pandemic-induced demand, and logistics companies, where positive pricing dynamics have boosted margins.

Sectors least resilient to our recession scenario include autos, capital goods, and aerospace and defense

In the moderate and full recession scenarios, the sectors most susceptible to rapidly increasing leverage include autos, capital goods, and aerospace and defense, where smaller sized issuers are predominantly price takers; paper and packaging, where issuers are struggling to address supply-chain constraints and demand for sustainable features has compressed margins due to a lag in price pass through); hotels and leisure, where leverage is already elevated due to the pandemic and where margins are under pressure from rising input costs and wage rises. Retailers' median leverage ratios are also forecast to nearly double in the full recession scenario due to the sector's high fixed costs (due to leases) and shrinking consumer spending. This could prove particularly challenging for issuers facing near-term refinancing risk, including Missouri TopCo Ltd. (Matalan), and Takko [Fashion S.à R.L.], as well as Kirk Beauty One GmbH, which trimmed cash-pay secured leverage to address business issues before the pandemic struck. Leverage ratios in the chemicals and building materials sectors could also see an increase in leverage by 3 turns due to high cyclicality, which is reflected in our adjustments to these sectors, and mounting gas supply risks. Certain issuers in the chemicals sector have had outlooks reverted to negative, on account of mounting energy supply risks, although liquidity is robust and there is ample headroom under our rating downgrade triggers (see "Various Rating Actions Taken On Several European Chemicals Companies On Gas Supply Risks," published Aug. 1, 2022). In building materials however, negative bias is currently low, cash buffers and liquidity are fairly robust, and we are yet to see signs of waning demand and negative rating pressures--apart from issuers exposed to gas flow disruptions and refinancing risk with maturities in 2023. Technology issuers in this rating category are forecast to see median leverage rising above 8x in the full recession scenario. These issuers typically have 'B-' ratings and fairly high leverage levels, but also strong free cash flows and asset-light businesses that should stave off rapid moves into the 'CCC' category.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Marta Stojanova, London + 44 20 7176 0476;
Secondary Contact:David W Gillmor, London + 44 20 7176 3673;
Research Contributor:Maulik Shah, CRISIL Global Analytical Center, an S&P affiliate, Mumbai
Additional Contact:Industrial Ratings Europe;

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