A deterioration of margins and earnings will impair the building materials sector's credit quality.

Under S&P Global Ratings' base-case forecast, tailwinds from increased home investment, heightened repair and remodel spending, and new homebuilding activity that began during the second half of 2020 are tapering off in 2023. We expect modest declines in revenue (about 5%-10%) and narrowing profit margins with EBITDA declining in the 10%-15% range for the rated building materials sector due to slowing demand for home repairs and construction. We also expect margins will be under pressure in 2023 as commodity, labor, and delivery costs remain constraining factors. While 95% of the outlooks in the rated portfolio are stable as of May 8, 2023, we expect a growing negative rating bias in the next year as the sector faces weaker earnings and higher financing costs.

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Our U.S. GDP growth forecast still calls for a shallow recession, but increased credit tightening, stemming from recent events in the banking sector has increased downside risks to our forecast. We expect the prolonged effect of inflation and elevated interest rates to pressure consumer discretionary spending on remodeling and renovations, while a rapidly cooling housing market adds pressure to the top line.

Overall, we expect repair- and remodel-exposed companies to be relatively less volatile than those exposed to new housing. However, discretionary consumer spending levels could affect demand for some higher-value building products such as cabinetry and bath fixtures. Revenue across the portfolio has been generally strong in recent years, but we expect decelerating growth and flat to low-single-digit revenue declines for the sector with commodity-based companies falling more sharply. According to the LIRA Index (Leading Indicator of Remodeling Activity published by the Joint Center of Housing Studies by Harvard University), year-over-year expenditures for homeowner improvements and maintenance will post a modest decline of 2.8 percent through the first quarter of 2024. We also expect total housing starts to be about 1.2 million units in 2023, a decline from 1.6 million in 2022 as the housing market rapidly cools down in response to sharply higher mortgage rates.

Despite weaker demand from the consumer, we expect an increase in nonresidential spending from investments in infrastructure to temper some of the declines in the cyclical residential end market. Indeed, we think issuers with exposure to the aggregates segment will remain more resilient compared to those exposed to discretionary products and new home construction. The Biden administration's $1.2 trillion infrastructure bill from November 2021 includes investment in roads, bridges, water systems, electricity grids, broadband, and health care. We believe the bill will result in an uptick in nonresidential spending with the market reflecting federal investments modestly in 2024.

We expect interest rates will stay higher for longer, pressuring credit metrics as demand slows.

The recent turmoil in the banking system could tighten access to credit, adding to downside risk and chances for a worsening recession. However, none of our issuers appear to be overly exposed to regional or challenged banks. We continue to expect a shallow recession in 2023 followed by a period of slow growth. S&P Global economists expect the federal funds rate to peak at 5.00%-5.15% by May of 2023. While the Fed raised rates by 25 basis points (bps) in March, and we expect another 25 bps hike in May as they continue to tame inflation, the trajectory of further rate hikes remains uncertain. As prices begin to stabilize, we expect the first rate cut in mid-2024.

We expect rising interest rates to contribute to weaker cash flow credit metrics this year, including EBITDA to interest coverage, resulting in potential outlook revisions or downgrades in the next year if performance is weaker than we expect. About 50% of building materials issuers are rated in the 'B' category given the high level of private equity ownership, which generally have aggressive financial policies and highly leveraged capital structures. Our ratings at the 'B' and 'B-' threshold generally place a greater focus on liquidity and capital structure sustainability. Companies at the highest risk for a downgrade are those exposed to rising debt service costs while simultaneously facing slowing demand, supply chain challenges, and higher costs for other inputs that collectively threaten to constrain cash flow and render debt burdens unsustainable.

We expect a higher interest burden from exposure to floating-rate debt to pressure interest coverage metrics given there is limited hedging protection for variable-rate debt. As credit underwriting standards tighten, issuers with highly leveraged capital structures may face challenging refinancing conditions. Higher borrowing cost and tighter access to credit could strain liquidity for issuers facing near-term debt maturities.

Lower-rated building materials issuers with high exposure to floating-rate debt or upcoming debt maturities face increasing downgrade risk.

We currently have nine ratings (or 15% of the rated building materials sector) at the 'B-' level. We believe these ratings face increasing downgrade risk given the potential for weaker operating results and cash flow pressure, in addition to narrowing credit cushions relative to downgrade triggers. Given their highly leveraged capital structures with expected average debt to EBITDA of 8x in 2023 and 2024, their capital structure may become unsustainable in a downturn where performance is more pressured than we anticipate. A large percentage of the capital structure is comprised of floating-rate debt, which could pressure credit metrics in the next 12 months given currently higher interest rates and limited hedging of rate exposure. However, there are no meaningful debt maturities over the next two years as many of our issuers rated 'B-' refinanced their capital structures and took advantage of lower interest rates in the past few years. As a result, maturities are pushed out, with maturity walls starting in 2027 with about $6.8 billion due 2027 and $6.9 billion due 2028. While we view the liquidity of issuers rated 'B-' as largely adequate, we see downside risk in free cash flow generation. As operating performance weakens, some issuers may face thinning covenant cushions. Still, with reduced investments in working capital due to slower conditions and deflating commodity costs, these companies could generate better free cash flows and support liquidity in the near term.

We therefore expect most of our 'B-' issuers will maintain stable outlooks over the next 12 months given limited refinancing risk, adequate liquidity, and despite modest pressure on operating performance and high exposure to floating-rate debt. Still, we will continue to monitor building material issuers' performance in a slower economic growth landscape, especially leading up to debt maturities for refinancing.

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