In the third quarter, the pace of new loan issuance fell sharply, down 42% from the previous quarter. Particularly, opportunistic activities like refinancing and repricing--which front-loaded the leveraged loan market in the first half of the year--have ebbed considerably in the face of rising U.S. interest rates. While this downshift may have caught some by surprise, the leveraged loan market appears to be on fundamentally stable footing, underpinned by solid economic momentum, ample liquidity, and strong demand from institutional investors (on that note, collateralized loan obligation (CLO) new issuance is on the pace to break last year's record. That, combined with the retail inflows to loan funds, have resulted in sustained demand for loans).

In the following sections, we discuss new loan issuance, the downward migration of our recovery ratings, as well as shrinking new issuer size, to help frame where the market stands today. We believe most of these trends will reverberate through the U.S. loan market for the remainder of the year.

LBO Did The Heavy Lifting In The Third Quarter

New loan issuance, including both pro rata and institutional, clocked in at a modest $46.7 billion in September 2018--the slowest September since 2015--finishing the quarter at $117 billion. In the past two years, September has been the comeback month after a typical summer lull, with new allocations on par with those in July and August combined. However, this was not the case this September, as primary issuance fell below July's level (see chart 1). The third quarter's tally was down a significant 42% from the second quarter and 20% behind the same period last year (data from S&P Global's Leveraged Commentary & Data [LCD]).

While refinancing activities have waned due to rising interest rates, leveraged buyout (LBO)-related transactions are steadily gaining traction. In the past quarter, a trio of mega-size LBO deals have garnered much of the attention. Collectively, the jumbo buyout of Refinitiv, Envision Healthcare, and Akzo Nobel Specialty Chemicals contributed a combined $16.25 billion of new loan supply. According to an LCD report, after three quarters of consecutive growth, LBO volume rose to a post-crisis high of $48 billion and was the third highest in 20 years, only behind the first two quarters of 2007.

Recovery Ratings Continue Their Downward Trend

As investors continue to take on new loans with a healthy appetite, our estimated recovery prospects for recent first-lien debt have declined. As chart 2 indicates, quarter by quarter, both the average and dollar-weighted average of estimated recoveries have generally slid since first-quarter 2017, when the leveraged loan market took off with record issuance and has been on the fast track ever since. It was during 2017 that both metrics had the biggest decline; they now stand at 65%, down 6% and 9%, respectively, from the beginning of 2017. When tallying up the quarterly numbers, the weighted average estimated recoveries of first-lien new issues were about 67% during the first three quarters of 2018 compared to 72% in 2017.

Chart 2

Against that backdrop, the share of '3' recovery ratings (meaningful recovery of 50%-70% expected in an event of payment default) continues to reach new highs (see chart 3). For the moment, the lion's share (63%) of new first-lien debt instruments we've rated in the past quarter had a '3' recovery rating. In contrast, the share of '2' recovery ratings (a more promising 70%-90% recovery), which averaged about 26% every quarter between 2014-2017, is now a distant second at 19%.

While the quarter-over-quarter changes are not necessarily dramatic, the cumulative effect is material. A cross-time comparison with earlier default metrics put the current readings deep below historical norms. The actual recovery rates for first-lien debt averaged 80% for rated companies that filed and emerged from bankruptcy between 2008 and 2017. Over the more recent five-year cohort of 2013-2017, the average stayed roughly unchanged at 82% based on an aggregate $66 billion of first-lien debt at default (from 155 rated debt classes), which represents 43% of total debt at default.

Chart 3

These migrations highlight the impact of the growing proportion of senior secured debt, namely term loan B, in the capital structure. Moreover, a great number of issuers today--particularly private equity sponsor-owned small issuers--are adopting an all-loan debt structure as opposed to the more traditional loan and bond split. Either way, the maneuver diminishes the cushion beneath the senior secured debt. In fact, of the 31 new companies for which we performed a first-time recovery analysis in third-quarter 2018, 30% have no junior cushion and half have cushion below 30%. On this point, our second-quarter update discusses the recent debt cushion trend in detail (please see "Leveraged Finance: U.S. Leveraged Loan Q2 Update", published Aug. 2, 2018).

In yet another sign of market vulnerabilities, institutional loans today have been predominately covenant-lite, which reduces the recovery outlook because we expect them to recover, on average, 10% less than loans with financial maintenance covenants. This expectation is drawn from our study presented in "Lenders Blinded By Cov-Lite? Highlighting Data On Loan Covenants And Ultimate Recovery Rates", published April 12, 2018. In brief, our review of the entities that emerged from bankruptcy between 2014 and 2017 indicates that covenant-lite first-lien loans recovered an average of 72% compared to 82% for noncovenant-lite loans.

The Door Has Swung Wide Open For Smaller Issuers

Though not systematically associated with our recovery assessment, we also find that recent new issuers have been decidedly leaning toward smaller scales. The influx of small issuers accessing the leveraged finance space for the first time indicates the market's growing tolerance and acceptance for greater risk, given the continued supply/demand imbalance and ample investor capital on the sidelines.

Table 1 compares the size of first-time issuers over the past three years, including both investment-grade and speculative-grade-rated issuers. We measured the companies' relative sizes based on the revenue and reported EBITDA of the most recent fiscal year at the time we issued a rating. Despite there being a very wide dispersion around the mean, some directional data has emerged. The new-issuer size fell sharply in 2017. Both average revenue and EBITDA more than halved in 2017, and have continued to descend so far this year. On the median basis, size shrank by roughly 35% over the two-year period.

The trend is even more pronounced when breaking down the data by EBITDA buckets (see table 2): 40% of the new issuers in 2016 came from the top bracket (reported EBITDA exceeding $150 million). That share plummeted to mid-20% in the following years. Instead, in 2017 and 2018, new issuers were weighted to the lowest bracket (those with reported EBITDA falling below $50 million but above the 0 threshold), at 40% and 36% of the total, respectively. Along with this shift, the share of companies reporting negative EBITDA has risen from 2% in 2016 to 8% in the first three quarters of 2018. This further signifies investors' willingness today to snap up companies' debt--even if they were cash flow negative for years. One high-profile name among the pack is WeWork Cos. Inc., which made its high-yield market debut in April. Similarly, many of these first-time issuers have experienced staggering growth at the cost of continuing large capital needs.

Table 1

Table 2

The slide in scale has an unsettling effect on borrowers' credit quality, as the size and scope of operations is often one of the key factors that shape a business' competitiveness in the marketplace, and a key factor in our business risk assessment. Relatively smaller companies will likely be more concentrated in terms of product offerings, number of customers, supplier base, or geography than their larger peers in the same industry. All of these will weigh on a business' ability to weather unexpected industry downturns, technological threats, or the greater cost of debt as interest rates continue to rise. In third-quarter 2018, we performed a first-time recovery analysis on 31 new non-financial corporate entities with a speculative-grade issuer credit rating. Of these newcomers, 90% are rated 'B' and below. On the recovery front, the median first-lien recovery is 66%, supported by a 25% cushion (also median). The lower ratings on the new issuers, should they persist, will likely translate into a higher default rate when the cycle turns if the vast majority of new issuers were not getting out of the gate on such shaky footing.