The pace of leveraged loan issuance plunged in December, as if all the tensions that have been simmering for the past year came to a boil. Concerns such as the build-up of corporate debt and rising borrowing costs cooled investor sentiments and played a role in why only $76 billion of institutional loans were allocated in the primary market during the last quarter of 2018. This is 23% lower than the same quarter last year and the lowest since the first quarter of 2016 according to S&P Global's Leveraged Commentary & Data (LCD). The recent shift in market tone has certainly clouded the 2019 outlook, but overall we expect new issue volume to likely recover most lost ground albeit gradually as issuers who were holding out for the right window begin to return to the primary market. As corporate fundamentals remain encouraging this far into the cycle, we expect the bulk of new 2019 loan issuance will continue to come from M&A and LBO transactions.

In the meantime, our recovery estimates for first-lien debt weakened throughout the majority of 2018, despite a marginal improvement in the last quarter. The consensus is the usual suspects have been at play, ranging from smaller junior cushion undermining first-lien position to the covenant-lite structure reducing lender protections. Here we look at the most significant developments (or resurgence of risk) of 2018.

Leveraged Loan Volumes And Trends

After a prolonged period of record issuance, the U.S. leveraged loan market lost its charm at the tail end of 2018. New issuance volume in the fourth quarter, including both pro rata and institutional loans, slid to $119 billion, approximately half of Q2's intra-year high of $209 billion. Much of the scale-back reflects the same concerns that have been gripping the high-yield and equity markets: collateral effects of interest-rate normalization, broadening of trade-related dispute, and slowdown in economic growth, to name a few.

Yet even with the sharp retreat in December, 2018 still stands as the second-strongest year in the post-crisis era. Total leveraged loan issuance in 2018 was $619 billion, only behind last year's record $650 billion. This is thanks largely to still attractive risk-adjusted returns on leveraged loans when compared with other asset classes. Another bright note--earnings growth has caught up with debt growth in 2018. Strong EBITDA growth, which swelled to a seven-year high of 13% in Q3 according to the LCD, lays the groundwork for M&A and LBO activities. Indeed, investors' risk appetite was put to the test in September when supersized LBOs came to market. The result? The demand was so strong that investors ceded more ground on the covenant battlefield. For example, Refinitiv landed what was considered to be extremely aggressive deal terms. This includes a broad definition of EBITDA that allows for adjustments for run-rate cost savings within 24 months, among other things. Such generous add backs may provide the company with additional borrowing capacity under incurrence covenants than would otherwise be permissible in comparable transactions.

When tallying the numbers, about 33% and 27% of institutional loans by volume backed M&A and LBO transactions last year, respectively. This surpassed opportunistic activities like refinancing and dividend recapitalizations, which collectively accounted for 33% of total institutional issuance during 2018. After last year's intense refinancing activity, rising borrowing costs (a combination of surges in interest rates and new-issue spreads) have squeezed out most remaining incentives for refinancing.

Chart 1

Recovery Trends In 2017-2018

Despite a downward trend for the full year, average recovery estimates inched up in the fourth quarter as the market tightened (see chart 2). The issue-weighted average recovery estimates for first-lien new issuance went up by a modest two percentage points. Though the change is insubstantial in historical terms, it marks an (if transitory) end to a period that was set in motion since the first quarter of 2017, when the leveraged loan market took off with record issuance. Over this two-year span, the average readings have generally been sliding, culminating in a decline of roughly 4%. The downward trend reversed only one other time during the period, exactly one year ago, but to a lesser degree. On the full-year basis, recovery estimates average about 65% compared with 68% in 2017. We believe the recent reversal is more likely attributable to Q4's much smaller observation size, and not representative of a substantial, long-lasting shift for the leveraged lending space.

Chart 2

Recovery rating distribution provides another look at how recovery became marginally more favorable amid the wavering conditions in Q4. Despite the small retreat, '3' recovery rating (indicating meaningful recovery of 50%-70% in an event of payment default) remains the most common assessment for first-lien new issues. The new-issue recovery space, which has traditionally more spread across a wider span, has in recent quarters converged to '3'. Currently, the recovery rating on 61% of new first-lien debt instruments that we rated in the past quarter is '3'. In fact, the number has remained above 50% for each quarter since Q2 2017, with an all-time high of 63% reached in Q3 2018. Before 2017, the number hovered around mid-40%, averaging about 45% between 2014 and 2016. With such a large portion now dipping into the '3' territory, the share of '2' recovery ratings (signifying a more promising 70%-90% recovery) is now a distant second at 18%. As elaborated below, we primarily attribute the downward shift in first-lien recovery ratings to the shrinking junior debt cushion.

While the quarter-over-quarter changes are not necessarily dramatic, the cumulative effect is significant. A comparison with earlier default metrics put the current readings well below historic norms. The actual recovery rates for first-lien averaged 80% for companies that filed and emerged from bankruptcy between 2007 and 2017.

Chart 3

The Story Of Debt Cushion

Recovery prospects for first-lien debt is a function of subordination. The following section provides an update on junior debt cushion and how it affects first-lien recoveries, to quantify the shift in debt mix and the resultant impact on recovery. Here, we define available cushion as the amount of subordinated junior debt as a share of the obligor's debt structure. Assumptions used in calculating debt cushion were detailed in our report "Lean Debt Cushion Threatens Recovery Prospects for Leveraged Loans in U.S.", published Nov. 30, 2017. For all issuers in 2017 and 2018, our sample consists of 1,181 and 1,383, respectively, non-financial U.S. corporate borrowers of one or more first-lien instruments, on which a recovery rating was newly assigned or re-reviewed by S&P Global Ratings within the study year. We then compared them against the first-time corporate issuers within the same period, as well as recent LBO borrowers in the second half of 2018. The chart below ranks the eight groups in the order of average cushion size, largest to smallest.

We expect a positive relationship between first-lien recoveries and junior cushion, meaning that the more junior debt in the capital structure, the more favorable the recovery prospects for the senior first-lien. Among all issuers in the past two years (including both new and existing), there was a marginal decline in the average cushion size in 2018. The difference becomes non-trivial for the first-time issuers: average cushion lags the broader sphere with 7.6% lower in 2017 (28.9% vs. 21.3%) and 8.8% lower in 2018 (28.3% vs. 19.5%). More telling, the trend is the most pronounced among LBO issuers, which cut the cushion further down to 16.5% in the last quarter of 2018. LBOs warrant special attention here as they represent the most leveraged and often the lowest rated borrowers in market. In total, we studied 34 issuers backing LBO transactions in the second half of 2018. Across their capital structures, 30% (10 issuers) have no cushion underneath, meaning they were financing solely through first-lien or priority debt.

Chart 4

The Story Of Growing Debt

To address lender's concerns over the rising debt levels and study the impact on recovery, we tracked the changes in debt exposure of the 212 non-financial companies that we reviewed in the fourth quarter. We used our estimated exposure at default (the amount of debt claims outstanding at the point of hypothetical default) as a proxy for overall debt exposure. We believe this is a meaningful measurement for the purpose of our study as it represents a key calculation in our recovery analysis for deriving recovery percentage for each debt instrument. We then compared a company's debt exposure in the fourth quarter with the debt amount that we calculated similarly at the last review. Our reviews often followed the companies' new financing transactions, business developments, or as a part of our annual review. The average time lap between two reviews is nine months.

As embedded debt gradually rolled off, about half of the borrowers across the sample achieved debt reduction. The chart below focus on those remaining borrowers that releveraged over the same time span (see chart 5). Still, the overall ramp up of debt was not significant--53% or 55 borrowers saw the size of their balance sheet debt rise within a modest 0%-10% range. More alarming, 15% or 16 borrowers' releveraging was more material (increased by more than 50%). This includes six companies that incurred add-on term debt in the fourth quarter, most following transformative events.

Chart 5

For most of the companies that releveraged, the additional borrowing has yet to move the needle from a recovery perspective. We revised our recovery estimates on the first-lien debt in only nine cases, resulting in a lower recovery rating. This includes waste services company GFL Environmental Inc., which upsized its B term loan add-on to $1.71 billion from $1.31 billion to back its merger with Waste Industries USA LLC. As a result, we revised our recovery rating on the debt to '2' from '1'.

Table 1

In a related study, we took a closer look at 'B-'-rated companies as they are already highly leveraged. Therefore, any additional debt will likely nudge them toward the 'CCC' territory. On this front, we reviewed 12 issuers that we rate 'B-' or below. All but one has a negative CreditWatch placement or outlook, and are widely held by collateralized loan obligations (CLOs; see list in table 2). The list ranges from specialty retailer PetSmart Inc. to educational technology company Blackboard Inc. Among the distressed credits, two companies in the past two years incurred add-on term debt: Solenis International LLC (to fund its merger with BASF's paper and water business) and Frontier Communications Corp. (to refinance existing bank debt).

Table 2