Leveraged loan issuance slid to $107.6 billion in the second quarter, wrapping up a disappointing first half despite healthy demand from collateralized loan obligations (CLO) investors, based on S&P Global's Leveraged Commentary & Data (LCD).
Only $70.7 billion of new institutional loans debuted in the second quarter of 2019, about half of the volume from the same period a year earlier (see chart 1). Including pro rata loans, total new issuance volume logged a 17% decrease from the already muted first quarter and the lightest quarter tally since the first quarter of 2016, according to LCD.
Following the record issuance seen in 2017 and 2018, so far 2019 has been slower. The economy and stress from trade tensions, mixed with negative press around leveraged loans and the growing preference for fixed-rate investments (given the signals from the Fed) underpinned the slowing pace of leveraged loan growth in the second quarter. Amid the uncertain market conditions, transactions backed by mergers and acquisitions (M&A) and leveraged buyouts (LBO) trickled in at a much slower pace. This stands in contrast to the same time last year, when the favorable macroeconomic outlook and tax cuts bolstered market confidence and fueled M&A appetite in the months that followed.
Deteriorating credit quality and aggressive capital structures remain concerns for investors. We believe lenders' increasing awareness of potential pitfalls in loan documents will lead to pushback against some of the more egregious loan terms. In this report, we take a fresh read on the latest recovery trends, and also a closer look at the weakest loan obligors (rated 'B-' with negative outlook) from a CLO perspective, as risk is inevitably at the forefront of loan investors' minds at this late stage of the credit cycle.
BSL CLOs' Exposure To Obligors Rated 'B-' Has Doubled Since 2017
The following section focuses on broadly syndicated loans collateralizing U.S. CLOs (BSL CLOs) rated by S&P Global Ratings. As the chart below shows, the share of loan obligors rated in the 'B-' and 'CCC' categories and lower held in U.S. CLOs has cycled through the recent history in a more or less synchronized manner. However, the two series have diverged since 2017.
The share of 'CCC' category and lower--the common measure of imminent risk of default and/or loss–-has declined notably over the period, down to 4.6% by the end of the first half from 7.4% at the height of the energy and retail slowdown. Meanwhile, 'B-' exposure has been on a fairly steep climb, nearly doubling since 2017 and surpassing 18% at the end of first half. Indeed, the last one and a half years have been record setting for the highest 'B-' share since inception.
Chart 2
There may still be room for 'B-' exposure to grow in the remainder of the year. Over 18% of obligors with loans held in U.S. BSL CLOs have a negative rating bias (either with negative outlook or a rating on CreditWatch with negative implications). Splitting the pool by issuer credit rating and rating bias shows that about 20% and 15% of 'B' and 'B-' rated obligors, respectively, had a negative bias as of the end of the first half, while only 3% and 4%, respectively, had a positive bias (see table 1). The net negative rating bias increases the risk of flooding the 'CCC' bucket of U.S. BSL CLOs, whose documents generally cap the holding at 7.5%, meaning any excess holding above such level would be marked down to market value within their overcollateralization tests.
Table 1
| Proportions Of Bias For Issuer Credit Ratings (%) | ||||||||
|---|---|---|---|---|---|---|---|---|
| Issuer Credit Rating | Negative Bias | Positive Bias | None | |||||
| BB- and above | 11.0 | 8.7 | 80.2 | |||||
| B+ | 17.8 | 8.3 | 73.9 | |||||
| B | 20.1 | 3.0 | 76.9 | |||||
| B- | 15.4 | 4.3 | 80.3 | |||||
| CCC+ and below | 65.1 | 0.1 | 34.8 | |||||
| Total | 18.7 | 5.4 | 75.9 | |||||
| Source: S&P Global Ratings. | ||||||||
As we consider 'B-' ratings on CreditWatch negative as 'CCC' generally for coverage purposes, we narrowed our focus to just the 'B-' borrowers with a negative rating outlook on June 30, 2019 (representing about 2.8% of the loans held in U.S. BSL CLOs)--the segment perceived as most vulnerable for entering the 'CCC' category. Breaking down our distress sample by GIC sector and on the aggregated balance held across U.S. BSL CLOs, we see that although there is no clear dominance of any single industry, there is slight concentration within media (11.5% of total volume of the distress sample) and health care providers and services (11.0%; see chart 3).
This ranking to some extent reflects CLOs' overall sector exposure, where media and health care providers and services are among the top three most widely held GIC sectors, behind only software.
Chart 3
Media obligors (under the GICS) led the pack, predominately the result of Advantage Sales & Marketing Inc., which is among the top 250 obligors most widely held in U.S. BSL CLOs (ranking 33rd overall in the second quarter). The California-based company provides sales and marketing services to consumer packaged goods companies and retailers in North America. On May 10, 2019, we lowered our issuer credit rating to 'B-' from 'B', primarily reflecting the company's sizable term loan that will come due in about two years, which we believe could be difficult to refinance given the continued tough conditions faced by sales and marketing agencies, and even more challenging if the U.S. economy goes into recession.
In addition to refinancing risk, adaptability to rapidly changing industry trends is another contributing factor to watch out for. Network performance software solutions provider Riverbed Technology Inc., the second most widely syndicated name on our distress list (one of the top 250 obligors held in U.S. BSL CLOs, ranking 101st overall in the second quarter), saw sharp declines in revenues and margin erosion in the back half of 2018. In conjunction with lowering the issuer credit rating to 'B-', we revised our business risk assessment to weak from fair, reflecting the company's weak operating performance, along with our belief that accelerating software-defined wide area network adoption trends and Riverbed's slow entrance into that highly competitive market increase the uncertainty that it can retain the customer base and market position it once enjoyed.
Another common theme across the sample is an acquisitive growth strategy and higher-than-expected integration related costs. In the case of dental support services provider Heartland Dental LLC, its accelerated pace of office expansion, along with increased one-time investments in 2018, has resulted in a significant increase in leverage (13.8x in 2018 from 9x in 2017). The negative outlook reflects increased execution risk and further EBITDA margin erosion. In our view, the profitability drag from opening new offices during the ramp-up phase will continue to pressure its EBITDA margins, which have dropped more than 200 basis points (bps) in the past year.
Recovery Trends Stabilized In The Second Quarter
Recovery is another point of stress, and we expect it to be meaningfully lower in the next downturn, particularly for aggressively structured deals. Average recovery estimate for first-lien new issues, our forward-looking measure of recovery in a default scenario, has bounced around 65% since its biggest slide in 2017. In the second quarter, the recovery metric deteriorated marginally, retreating to 64%.
A cross-time comparison with earlier default metrics would put recent estimates below historical norms. The actual recovery rates for first-lien averaged 80% for rated companies that filed and emerged from bankruptcy between 2008 and 2017. In the more recent five-year cohort (2013-2017), the average stayed roughly unchanged at 82% based on an aggregate $66 billion of defaulted first-lien debt (from 155 rated debt classes), which represents 43% of total defaulted debt.
Further, the recovery rating distributions reveal reduced dispersion around the mean. A '3' recovery rating--indicating meaningful (50%-70%) recovery in the event of a payment default--remains the most common for first-lien new issuance. In the second quarter of 2019, 64% of new issuance by count are from that segment, an all-time high since we started tracking this data in 2014 and up 3% from a year earlier.
The observation of recovery slimming down coincides with an increasing exposure to the technology sector: the presence of tech obligors (including software and services, high tech equipment, and semiconductors) in the leveraged finance space has expanded considerately in recent years. As detailed in our recent report "When The Credit Cycle Turns: Recovery Prospects In The U.S. Technology Sector," published on July 16, 2019, our recovery expectation for tech borrowers is decidedly below all corporate averages. As of the beginning of second quarter, about 21.1% of outstanding first-lien senior secured issues have a recovery rating of '1' (90%-100%); for tech, this share was significantly lower to 2.4%.
Chart 4
This report does not constitute a rating action.
| Primary Credit Analyst: | Hanna Zhang, New York (1) 212-438-8288; Hanna.Zhang@spglobal.com |
| Secondary Contacts: | Daniel Hu, FRM, New York (1) 212-438-2206; daniel.hu@spglobal.com |
| Olen Honeyman, New York (1) 212-438-4031; olen.honeyman@spglobal.com | |
| Analytical Manager: | Ramki Muthukrishnan, New York (1) 212-438-1384; ramki.muthukrishnan@spglobal.com |
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