The COVID-19 pandemic, which ended the longest economic expansion in the U.S., appears to be far from over, even as the economy emerges from possibly the shortest recession in the U.S. history. In its wake, the pandemic has caused material damage to the business and creditworthiness of companies in almost all corporate sectors, though speculative-grade companies have borne the brunt of it. With states gradually opening up and lifting lock down measures, albeit in fits and starts, the initial liquidity crisis has given way to a long, slow, and difficult road to recovery for U.S. corporates.

Interestingly, the U.S. leveraged finance market experienced lopsided growth in the second quarter. According to S&P Global's Leveraged Commentary & Data (LCD), the high-yield issuance jolted upright with a record of $140.5 billion, while the institutional loan issuance plummeted to $44.3 billion, the lowest in any quarter over the past four years. For the first time since 2009, the $54.8 billion quarterly issuance for secured high-yield debt was more than that of institutional loans. We attribute this asymmetrical growth to a few factors. On the supply side, high yield provides quick and easy access to the capital markets, and beleaguered companies needed swift access to liquidity. From a demand perspective, high yield got a boost from the Federal Reserve's intervention and signaling, as evidenced by the sharp tightening of spreads and strong retail inflows. This stands in contrast to leveraged loans, which have seen a slowdown in demand for collateralized loan obligations (CLOs), the single largest buyer of new leveraged loans.

In this quarterly installment, we expand on the pandemic's repercussions on recovery ratings, with a focus on loans that serve as collateral for broadly syndicated CLOs in the U.S. Our analysis suggests that the impact of economic shocks on recovery ratings is less than people may expect. Also in the second quarter, the latest cohort of first-lien new issues featured the highest quarterly average recovery estimates in two years--71%--quite a deviance given the averages have consistently hovered in the mid-60%s.

Recovery Ratings Have Withstood Distress

Since early March, we have downgraded over 900 corporate, financial institution, and sovereign issuers across the globe, yet the impact on recovery ratings thus far has been limited. Such stability around recovery ratings is to be expected, as S&P Global Ratings' recovery analysis by design, already looks through to a company-specific default scenario. More specifically, we assume a drop in an enterprise's revenue and earnings such that it cannot meet its interest and scheduled principal payments, causing a default. As part of our hypothetical default scenario, we generally envision an economic deceleration that leads to steep demand declines. Hence, the pandemic-induced slump in revenue and earnings by itself should not materially change our view of the recovery prospect of a debt instrument, even as it increases the risk of a company default.

Our analysis provides further proof that recovery ratings could weather a fair amount of operating underperformance (chart 1). Since early February, we have taken 731 rating actions on entities with loans held in U.S. CLOs that we rate. Downgrades accounted for 70% of these actions, and of them, 136, or about 30%, also experienced negative changes to the recovery outcomes. Of those 136, 78 ratings are within the same recovery rating category (see table 1), meaning the impact to point estimate was modest and not enough to trigger a shift in rating category. In another 54 instances, we revised the recovery rating, and of these revisions, four were by more than one recovery rating category. This includes commerce platform Travelport Finance (Luxembourg) S.A.R.L, which had transferred over $1 billion in intellectual property rights to an unrestricted subsidiary out of the collateral package and subsequently borrowed against it. The resulting structural subordination led us to revise the recovery rating on the existing first-lien term loans and revolver to '4' (45%), down from '2' (75%).

Chart 1

Table 1

Incremental Borrowing Drove Recovery Rating Changes

Delving into the rationale behind recovery changes reveals changes to the capital structure--such as taking on new debt and reshuffling of capital structure priorities--drove most of them.

Unsurprisingly, weathering the severe downturn has come at the cost of incremental borrowing. Companies proactively drew down revolving credit lines to build up their cash buffers at the beginning of the pandemic. In some cases, companies that realized they would not be in compliance at the end of the first or second quarters fully drew any remaining commitment because covenants are calculated based on trailing EBITDA. Later on in the second quarter, as the capital markets reopened and funding costs dropped, many of these companies replaced revolving credit draws and/or 364-day bridge facilities with new debt, turning short-term borrowing into a more permanent piece of the debt structure. In addition, the unprecedented nature of the downturn and the uncertainty of its duration complicate damage assessments. Therefore, even companies in their recovery phases are more likely to keep cash reserves on their balance sheets for longer as opposed to repaying debt. For now at least, low interest rates have alleviated the burden of additional debt.

Exposure to potential value erosion is somewhat tied to issuers' creditworthiness. Recovery ratings on 'BB' rated issuers have been relatively unaffected because they tended to have more incremental debt capacity and stronger credit fundamentals before the pandemic. In comparison, 'B' rated issuers' recovery prospects are more susceptible to additional debt. This is especially true for unsecured and junior claims because they can easily get bumped down the payment hierarchy. The extra debt load and the resulting subordination has contributed to a significantly lower recovery expectations because in most cases, our valuations of the enterprise at emergence were unchanged.

Another interesting example is our revision of recovery ratings on bedding manufacturer Serta Simmons Bedding LLC's senior secured debt. The company completed a series of distressed debt exchanges in July, swapping out a portion of existing first-lien and second-lien debt for super-priority second-out debt and issuing new super-priority first-out debt. It exchanged $992 million of first-lien debt and $300 million of second-lien debt for $851 million of super-priority second-out debt, and it issued $200 million of new super-priority first-out debt provided by the debt-exchange lenders. Recovery expectations for non-participating first-lien lenders under the remaining outstanding term loan were severely diluted, and we revised the recovery rating to '6' from '3', given the material amount of priority debt ahead of the term loan.

Industry-specific troubles are also responsible for diminishing recoveries. We recently cut our estimated value of various aircraft and used cars because of declining travel demand, which fell more than we previously factored into our recovery analysis. Car renter Avis Budget Group Inc. offers a good illustration--we now expect lower realization rates (down 5% from our previous assumption) on its vehicles that serve as collateral as we expect the company to encounter difficulties disposing of its fleet in a weak used-car market. This could potentially erode the enterprise value, and it led us to revise our recovery rating on Avis' secured and unsecured debt downward. For some mall-based retailers, the drop in demand has been more secular than cyclical. We are seeing an acceleration in the collapse of brick-and-mortar retailers. When we downgraded department store operator J.C. Penney Co. Inc. to 'D' after it filed Chapter 11, we also revised downward our recovery rating on its first-lien senior secured debt, owing to the decline in the company's appraised real estate collateral value. The chain retailer has struggled for years to adapt its business model to the challenging domestic department store space and has taken on large amounts of debt. More recently, its business prospects have sharply deteriorated because of the disruptions from COVID-19 and recessionary conditions.

New First-Lien Issue Recovery Prospects Have Improved

Recovery outlook on first-lien new issues, measured by the average of rounded recovery estimates, rose to 71% in the second quarter, a substantial improvement from the past few quarters (chart 2). In our view, such a rapid rise is likely a transient phenomenon driven by an influx of high-quality debt--mostly by higher-rated entities, such as fallen angels of sectors most severely affected by the pandemic--not necessarily a fundamental deviation from its general downward trend.

Royal Caribbean Cruises Ltd. and Carnival Corp., two prominent names in the cruise industry, both completed senior secured transactions in the second quarter, raising more than $10 billion first-lien secured debt combined to enhance liquidity, and we assigned all instruments a '1' recovery rating with a 95% rounded estimate.

Airlines are also falling victim to the extreme disruption to travel and tourism. Delta Air Lines Inc. raised $5 billion of secured debt in April by pledging certain route authorities and related takeoff and landing slots, as did many of its aviation peers. We assigned '1' recovery ratings to the new notes and term loan, indicating our expectation for very high recovery in the event of a payment default. Another example of high-credit-quality debt borrowed by 'BB' rated entities is wireless carrier T-Mobile US Inc., which completed its long-awaited merger with Sprint and brought a rare mega-transaction to the market amid the pandemic.

Despite the recent uptick in the average metrics, our estimated first-lien recoveries as a whole remain at historically low levels. The following chart shows the quarterly average that dates back to early 2017 when the U.S. leveraged loan market saw record levels of new issuance. Since then we see the average trend towards mid 60%, at about 66% in 2019 and 65% in 2018, a substantial decline from its 80% historical average (based on actual first-lien recoveries of 241 U.S. companies that filed for Chapter 11 between 2008 and 2017). As the default tally continues to rise, historically low recoveries have become a source of tension.

Chart 2

Accordingly, our latest breakdown by recovery rating category reveals a much smaller role played by the '3' category: About 46% of first-lien new issuance in second-quarter 2020 had a '3' recovery rating, implying 50%-70% recovery in an event of payment default. While still the largest category by issue count, it is the second-lowest share in over three years, plunging well below its 58% three-year average and only greater than the 43% in first-quarter 2017. At the same time, higher recovery assessments, such as those with recovery ratings of '1' and '2' (indicating 70% or more recovery) rebounded. When combined, they represent 45% of total issuance by count, a considerable increase from 27% in the first quarter. The first quarter's exceptionally high concentration of '3' recovery ratings is mostly a reflection of the pre-pandemic risk appetite: The market was still highly accommodating to new deals in the first two months of 2020, and the primary markets saw a strong issuance trend before it essentially dried up in March.

Chart 3

The decline in recovery outlook is built on years of deterioration of issuer credit quality. To get a better sense of the depth of deterioration and how it manifests in recovery assessments, we scanned all first-lien senior secured tranches outstanding as of July 1, 2020. Unsurprisingly, 'B' category rated entities represent most of the speculative-grade issuers (chart 4). The recovery rating distribution by issuer rating indicates that there is a notable dispersion in recovery prospects between first-lien tranches issued by 'BB' and 'B' rated entities, with the former having the largest bulk in the top-tier '1' recovery rating category (90%-100%), while the latter is weighted toward the mid-tier '3' category (50%-70%). This difference is largely driven by what we mentioned earlier: 'B' or below rated issuers--characterized by small scale, private equity ownership--have increasingly relied on first-lien-only structure. By maximizing the first-lien layer of the capital structure, they can keep the overall interest rate low while still making the deal palatable to institutional CLO investors.

Chart 4

We also looked at second-quarter first-lien issuance volume by industry (chart 5). The media, entertainment, and leisure sector is again the largest issuer group, contributing more than $30 billion. It was boosted by issuance in some of the most highly affected subsectors such as cruises, gaming, and gyms. Telecommunications followed at $24.3 billion, of which T-Mobile alone accounted for $23 billion in secured notes and term loan. In an unusual occurrence, regulated utilities also ingrained its place near the head of the pack, having issued $13.7 billion in the quarter. The volume, however, was entirely attributable to the bankruptcy exit financing of California utility holding company PG&E Corp. and its subsidiary, Pacific Gas & Electric Co. Furthermore, these two sectors also had the highest recovery estimates on average, 89% and 86%, respectively, well above the all-industry average of 71%.

Chart 5

Related Research

• Serta Simmons Bedding LLC's Recovery Rating Profile, July 6, 2020
• CLO Spotlight: U.S. CLO Exposure To Negative Corporate Rating Actions (As of June 28, 2020), June 30, 2020
• Risky Credits: The Drop-Off To The 'CCC' Rating Category From 'B-' Still Looms Large, June 29, 2020
• COVID-19 Heat Map: Post-Crisis Credit Recovery Could Take To 2022 And Beyond For Some Sectors, June 24, 2020
• U.S. Leveraged Finance Q1 2020 Update: Recovery Ratings Face Limited COVID-19 Disruption, April 23, 2020
• A 10-Year Lookback At Actual Recoveries And Recovery Ratings, Feb. 4, 2019