Key Takeaways
- Corporate defaults, which vary in nature, rose during the pandemic-induced recession and are now trending lower.
- Selective defaults, often the most common default, evidence the most variations of terms, ranging from pay-in-kind (PIK) interest to below-par principal repurchases.
- How defaults are timed and measured can affect collateralized loan obligation (CLO) credit quality.
Investors are aware of the large universe of low-rated companies that face increased default prospects because of the 2020 economic downturn, high debt levels, and the still-uncertain pace of recovery in 2021 and beyond for some sectors. We recently updated our expectations for the recovery of credit quality for corporate issuers by sector in "COVID-19 Heat Map: Some Bright Spots In Recovery Amid Signs Of Stability," published Feb. 17, 2021, as well as our view of trends for issuers rated 'B-' in "Risky Credits: Net Upgrades And Higher Oil Prices Offer Some Relief To The Weakest-Rated Companies In The U.S. And Canada," published March 17, 2021.
Defaults of speculative-grade companies rose during 2020; because of the solid economic tailwind, we now expect defaults to decline from the trailing-12-month February 2021 figure (6.4%) to 5.5% (but remain above the long-term average (4.2%) over the coming months and quarters). (See: "U.S. Speculative-Grade Corporate Default Rate Forecast For Year-End 2021 Falls To 5.5%," published March 30, 2021, and "Default, Transition, and Recovery: The S&P/LSTA Leveraged Loan Index Default Rate Forecast For Year-End 2021 Falls To 2.75%," published April 20, 2021.
This commentary explains our perspective on corporate defaults, including our outlook for leveraged loan default rates; the two types of issuer rating defaults evidenced by either an 'SD' (selective default on one or more issues, while other issues remain current) or 'D' (typically a general default); and some of the potential consequences of these defaults within CLO transactions, which hold more than 60% of all outstanding leveraged loans. While we provide examples of historical precedents, please see our relevant criteria for more information.
What Is Our Default Forecast For Leveraged Loans?
Our U.S. speculative-grade default forecast is 5.5% (on an issuer count basis), covering all forms of defaults (selective defaults or the failure to pay interest and/or principal on any debt, or a bankruptcy filing) for the trailing 12 months ending Dec. 31, 2021.
In late 2020, we introduced our default-rate forecast for the S&P/LSTA Leveraged Loan Index (LLI), which we now believe will decline to about 2.75% on a trailing 12-month basis at year-end 2021 (also on an issuer count basis, but this forecast only includes conventional defaults on loans, not bonds, and it excludes selective defaults, consistent with the default definition used by the LLI).
Chart 1
Chart 2
What Are Characteristics Of Companies Rated In The 'CCC' and Near-'CCC' Categories?
The lower end of the rated speculative-grade universe expanded in the years prior to the onset of the COVID-19 pandemic and global recession as investors sought yield. Not surprisingly, pandemic-containment measures and lower oil prices had a severe and sharp negative economic effect on the creditworthiness of almost all sectors--and the low end of speculative grade in particular. The downturn and consequent downgrades led to a record number of issuers in 'CCC' category and below (chart 3), though the 'CCC' category continues to decline from peak levels because of both upgrades and fewer downgrades. Issuers rated 'CCC+' composed about 12% of all speculative-grade issuers as of mid-April.
Chart 3
In our view, issuers rated 'B-' typically have capacity to meet financial commitments--a sustainable capital structure, for example--but this ability could be easily impaired by mild levels of underperformance or adverse shocks. An example is Pluto Acquisition I Inc., a home health, personal care, and hospice services provider rated 'B-/Stable'. We based that rating on our expectation of minimal free cash flow and elevated leverage for the following 12 months, but we believed the company was well-positioned to benefit from potential tailwinds in the home health industry. (See our research update, "Pluto Acquisition I Inc. 'B-' Ratings Affirmed; Outlook Revised To Stable From Positive On Cash Flow Pressures," published June 19, 2020.)
In contrast, for 'CCC+' rated issuers, we consider an eventual default highly likely (though not inevitable), even though there may not be a near-term liquidity concern. For example, our 'CCC+' rating on Innovative Water Care Global Corp. reflects continued adverse operating trends, elevated operating costs, and high fixed charges that drive an expectation of negative free operating cash flow for at least the near term. (See our research update, "Innovative Water Care Global Corp. Downgraded To 'CCC+' On Weak Operating Performance; Outlook Negative," published June 17, 2020.)
We view a default as increasingly likely for issues rated lower than 'CCC+' (table 1). While selective defaults can be difficult to predict, we seek to have a company in the 'CCC' category for 12 months before it defaults.
Table 1
Anticipated Time To Default By Issuer Credit Rating | ||||
---|---|---|---|---|
Issuer credit rating | Anticipated time to default | |||
CCC+ | More than 12 months away | |||
CCC | Within 12 months | |||
CCC- | Within 6 months | |||
Source: S&P Global Ratings. |
Not all issuers with a rating in the 'CCC' category will default, of course. In some cases, we've lowered issuer credit ratings to the 'CCC' category and then subsequently raised the rating back out of the 'CCC' category. Delivering better performance, perhaps in conjunction with meaningful refinancing, would be one possible path out of the 'CCC' category. (See "A Round-Trip Ticket: Some Companies Downgraded To 'CCC+' Could Be Headed To 'B-' As The Economy Recovers," published Aug. 7, 2020.)
Chart 4
What Are The Differences Between 'D' And 'SD' Ratings?
We rate to the original promise to pay on debt obligations. An issuer credit rating is lowered to 'D' if the default is, or is expected to become, a general default on debt (e.g., a bankruptcy filing or general restructuring) or 'SD' if a company experiences a selective default--the company defaults on some of its debt obligations (and those issue ratings are then set to 'D') but we expect it to remain current on other debt issues. A selective default may arise in instances when a company engages in what we consider to be a distressed exchange on a debt issuance while it remains current on other (presumably more senior) debt issues.
Our criteria specify two factors for a transaction to be a viewed as distressed exchange: first, that the issuer is distressed, meaning a conventional default for the company is likely over the near to medium term, and second, that the transaction on the affected securities offers debtholders less than the original promise without adequate offsetting compensation.
Once an issuer credit rating has been set to 'SD' we will typically reevaluate the company's creditworthiness when we have adequate information about the modified capital structure. This can often happen within a week or so after the original downgrade of the issuer credit rating to 'SD' if we have final capital structure details. In a general default, whether the result of a bankruptcy filing or a broad out-of-court restructuring, we may assign a new issuer credit rating upon emergence or completion of the restructuring, though this is unlikely to occur as rapidly as a revision of the issuer credit rating from 'SD' given the typical complexity and negotiations of a general default.
An interesting example of a selective default is industrial products manufacturer company Jason Holdings Inc. In August 2019, we lowered the issuer credit rating to 'CCC+' on continued poor operating performance for second-quarter 2019, when the company underperformed our previous forecast for sales and profitability. Facing substantial upcoming debt maturities, the company announced it had engaged advisers to explore strategic alternatives, including a potential sale. In April 2020, we lowered the issuer credit rating to 'SD' following Jason's decision to not make the $2.3 million interest payment due on its $89.9 million outstanding second-lien term loan and enter into a 30-day forbearance agreement with lenders. Jason remained current on all required interest and principal payments under its first-lien credit facilities. But, we thought it was likely that negotiations with the first-lien lenders would result in a restructuring of the debt that we would consider distressed within the 30-day forbearance period, subject to potential extension.
In June 2020, Jason ended its forbearance agreement and entered into a restructuring support agreement with some of its senior secured lenders. In that case, we lowered the rating to 'D' from 'SD' because we expected the company would restructure through a prepackaged Chapter 11 bankruptcy filing. In August 2020, we assigned a 'CCC+/Negative' rating to Jason on the company's emergence from Chapter 11.
What Are Some Examples Of Selective Defaults And Transactions That Were Not Considered Selective Defaults (And Why)?
An exchange offer that we determine to be distressed, but which also provides adequate offsetting compensation, is not considered a selective default. The exact amount of compensation required to be considered adequate depends on the severity of the situation, including a company's proximity to a conventional default and what its potential options are. For example, an entity rated 'B-' would ordinarily need less compensation for a maturity extension than one rated 'CCC-', given the level of default risk implied by the rating.
Example: Selective default because of the deferral of interest payments not offset with adequate compensation
A company rated 'CCC+/Negative' amended its second-lien term loan to allow it to make PIK interest payments for the quarters ended March, June, and September 2020, paying 50-100 basis points of additional PIK interest, to preserve near-term liquidity. We viewed the amendment as tantamount to default, given the distressed financial position of the company and our view that the incremental interest did not represent adequate compensation to offset the delay in cash interest payments because of the PIK feature, which constitutes less than the original promise to lenders. In our view, the marginally higher PIK coupon does not offset the uncertainty about the ultimate payment of the deferred amounts and the additional payment risk the lenders will be exposed to from the additional debt.
Example: A distressed exchange that offered adequate offsetting compensation
A 'CCC+' rated company amended its term loan agreement so that most of the interest the company owed in the first half of 2020 was PIK rather than cash. The interest rate rose significantly to 14% (13% PIK, 1% cash) and various terms were added, including a liquidity test until trailing 12-month EBITDA exceeded $200 million, asset sales limits, and mandatory term loan prepayments. In this instance, we did not lower the issuer credit rating to 'SD'.
When Is A Below Par Debt Repurchase Considered A Selective Default?
Open market purchases of debt by an issuer can also be considered a selective default, depending on the anonymity of the purchaser, the level of discount to par, and the proximity of the company to default. For example, in September 2020, Anchor Glass Container Corp. announced to its lenders its intent to offer its second-lien holders the ability to sell a portion of their share of the company's second-lien debt in exchange for up to $60 million of first-lien debt through a Dutch auction process. This transaction would reduce the company's debt burden by about $23 million because of the discount, and we said the cash flow would improve slightly, given the lower interest rate on the new first-lien debt. We viewed the proposed exchange as tantamount to default because lenders received less than the original promise of the security. We lowered the issuer credit rating to 'SD' when the transaction was completed, and we subsequently raised the rating to 'CCC+/Negative'. (See "Anchor Glass Container Corp. Downgraded To 'SD' On Completed Distressed Debt Exchange; Debt Rating Lowered To 'D'," published Oct. 9, 2020.)
On the other hand, a 'B+' rated midstream energy partnership, NGL Energy Partners L.P., disclosed that between March and May 2020, it had repurchased about 4% of its outstanding debt at market prices that were well below par. Given our assessment of the company's capital structure as sustainable and the limited about of debt repurchased, we viewed this transaction as opportunistic, rather than distressed.
When Do Priority Shifts (Priming) Constitute A Selective Default?
Another consideration in determining when debtholders are receiving less than the original promise is when ranking of the securities is altered to a more junior position. This only applies if there is an actual change to the terms of the original credit agreement or indenture, not just a priming debt issuance that is implicitly permitted by the documents. For example, consider the following 'CCC-' rated consumer product company. A subset of Renfro Corp.'s existing term loan lenders amended the loan agreement to allow up to $20.2 million of borrowings under a new senior term loan facility ($10.1 million of new money and $10.1 million rolled up from existing term loan lenders). We viewed this transaction as tantamount to a default on the term loan because the existing term loan lenders would be in a disadvantaged collateral position relative to the new debt, such that they would receive less than the original promise, and the company was having difficulty meeting its obligations. Renfro did not offer any compensation to its existing term loan lenders who chose not to contribute new money in the transaction. (See "Renfro Corp. Downgraded To 'SD' From 'CCC-' On Super-Priming Term Loan Issuance; Priming Term Loan Rating Lowered To 'D'," published Feb. 19, 2021.)
What Is The Propensity For Repeat Defaulters?
We are seeing an increase in issuers with multiple distressed exchanges, leading us to conclude that the initial exchange is often insufficient to align the company's capital structure with the business. The largest cohort of these multi-default issuers has defaulted twice (either to another selective default or a missed interest payment or bankruptcy). However, in recent years, there has been an uptick in issuers that have had multiple selective defaults ('SD' each time); some have defaulted three, four, and even five times. Nearly 80% of first defaults for issuers with multiple defaults are distressed exchanges.
What Trends Exist In Post-Default Debt Recovery Rates?
Our recovery rating performance research shows that actual recovery rates on first-lien debt (actual recoveries are estimates because there is not a clear, objective measure of actual recoveries for most debt because creditors are generally repaid with new securities rather than with cash) were lower than in the past, varied by sector, and were affected by levels of junior debt cushion.
- First-lien recoveries averaged 71% from2018 through the first half of 2020, down from 80% during the prior 10-year period. Interestingly, the first-lien recoveries from 2013 to 2017 were even higher at 82%.
- Since 2018, first-lien recoveries were low in the retail (eight companies) and consumer (five companies) sectors, averaging 56%-58%, but they were higher in the oil and gas sector (14 companies), averaging 94%.
- Debt cushion matters. First-lien debt recovery is highest--at an average of 90%--when there is junior debt in the debt structure, or debt cushion of 60%-70%.
Recovery ratings suggest that future recovery rates will remain under pressure because our estimated recoveries on newly issued first-lien debt since first-quarter 2017 have generally been 10%-15% lower than the longer-term historical averages of actual recoveries (our estimated future recovery rates generally average in the mid-60% area). Primary drivers of lower future recovery expectations include higher total and first-lien debt leverage. This is because of an influx of newly rated private equity-owned firms with high debt leverage necessitated by high purchase price multiples (despite high equity contributions used to help fund these deals). Because first-lien debt is often the cheapest form of debt, the use of first-lien-only and first-lien-heavy debt structures (with a limited cushion of junior debt) has been widespread. The dominance of covenant-lite term loan structures has also been a contributing factor to lower first-lien recovery rates. Historical data on actual recoveries shows that covenant-lite term loans have lower recoveries than their counterparts with covenants; average and median recoveries that are 11% and 34% lower, respectively.
- Excluding oil and gas, as well as retail and restaurants, the gap between covenant-lite and non-covenant-lite term loans are larger at 26% and 40%, respectively.
- Covenant-lite term loan structures also have higher event and pricing risk.
Our recovery methodology generally produces lower recovery estimates for covenant-lite term loan structures, all else equal. However, we view other factors, such as first-lien leverage, overall leverage, and junior debt cushion as more important for recovery levels.
Higher first-lien debt levels also tend to diminish recovery expectations for the junior debt sitting behind a thicker layer of higher-priority debt.
(See "Settling For Less: Covenant-Lite Loans Have Lower Recoveries, Higher Event And Pricing Risks," published Oct. 13, 2020, and "From Crisis To Crisis: A Lookback At Actual Recoveries And Recovery Ratings From The Great Recession To The Pandemic," published Oct. 8, 2020.)
What Risks Beyond Debt Mix Could Lower Recovery Rates Given Default Lower Than Expected?
There has been an uptick in the number of transactions in which companies under stress have aggressively restructured their debt outside of a formal bankruptcy process. Here, they use controversial tactics to subordinate certain existing lenders (as with Serta Simmons Bedding LLC,and Boardriders Inc.), or they transfer collateral to nonobligors for the benefit of new creditors (as with J. Crew Group Inc., Travelport Finance (Luxembourg) Srl, and Revlon Inc.). Such events can affect the recovery prospects for existing creditors (positively for some and negatively for others). Even so, we do not factor these types of event risks into our initial ratings, because in our view, these risks are not foreseeable or quantifiable, and we do not believe that rating to a worst-case scenario is reasonable or adds value for investors.
Such transactions remain uncommon, notwithstanding the high-profile nature of many of these cases, and we have been monitoring these situations to see whether there is an analytical basis for factoring these difficult to quantify and predict risks into our ratings on a prospective basis. Our initial dataset includes tracking tactics and amounts, as well as other details such as sponsors, key lenders, industries, advisory firms, and law firms. In the meantime, we will factor these risks into our recovery ratings as part of our ratings surveillance as transactions occur.
How Do CLO Transactions Treat Loans Or Bonds From Companies Rated 'SD' or 'D'?
The quantitative parts of our CLO analysis look to the par value of performing assets in a CLO's collateral pool. We then assess the ability of these assets to make required interest and principal payments on the CLO notes under various default scenarios associated with our rating levels. Once a company has seen its issuer credit rating lowered to 'D' or 'SD', it may no longer be appropriate to give full par credit for the company's loans or bonds under our criteria. But from the CLO's perspective, there can be a big difference between a default and a selective default.
For companies that have seen their rating lowered to 'D', the question of whether to give full par credit is straightforward enough. The company issuing the debt has, after all, defaulted. Accordingly, our analysis reduces the carrying value of the asset, rather than giving par credit for companies that have seen their rating lowered to 'D'(see "Guidance: Global Methodology And Assumptions For CLOs And Corporate CDOs,"published June 21, 2019). We apply the same treatment to companies with ratings lowered to 'CC' because under our ratings definitions, we assign this rating to companies we view as having a virtual certainty of defaulting, even if it hasn't happened yet.
But what about companies rated 'SD' that default on some, but not all, of their obligations? A selective default of a company is still a default, but here the analysis becomes a bit more complicated because the loans held within CLO transactions--those typically more senior in the corporate debt stack--are likely not among the obligations the company has defaulted on. In fact, in some instances, the loan holders (including CLOs) could even end up coming out ahead. Recall the Anchor Glass case outlined above, where a lower-rated company offered to buy back its second-lien debt at a discount to par, a step we considered a distressed exchange, which led us to lower our rating on the company to 'SD'. In that case, the first-lien loans held by most of the CLOs remained current on their payments, and the company came out the other side of the 'SD' rating with slightly less leverage because it was able to retire some outstanding debt at a discount to par, after which we raised the issuer rating back to 'CCC+'.
The timing of a rating change on a company to 'SD' can affect CLO manager reporting, particularly if it coincides with one of the CLO's payment dates. The corporate ratings team typically seeks to raise an issuer credit rating from 'SD' within a few days if it has sufficient information on the company's post-'SD' capital structure. Because of the differences between a 'D' and an 'SD' rating, our CLO criteria treats them differently under certain circumstances. While our CLO analysis treats companies rated 'CC', 'D', and 'SD' as defaulted, our CLO analysis may allow certain debt from companies rated 'SD' to be carried at par if they meet specific conditions outlined in our CLO criteria guidance. For shorthand, these obligations are referred to as "current pay obligations"). In the case of Anchor Glass, some CLOs were able to carry the senior loans at par because:
- The loans held by the CLO were current on all payments that were contractually due, including interest and principal payments; and
- The market value of the obligation held by the CLO was more than 80% of par.
CLO transaction documents may outline other conditions in addition to these, including a maximum proportion of a CLO collateral pool that may be subject to this treatment, as well as the rating the asset should be carried at within the CLO. We've outlined other conditions in the CLO criteria guidance, including a maximum proportion of a CLO collateral pool that may be subject to this treatment, as well as the rating that we will use for the asset when doing our analysis.
Related Research
This report does not constitute a rating action.
Primary Credit Analysts: | Robert E Schulz, CFA, New York + 1 (212) 438 7808; robert.schulz@spglobal.com |
Ramki Muthukrishnan, New York + 1 (212) 438 1384; ramki.muthukrishnan@spglobal.com | |
Steve H Wilkinson, CFA, New York + 1 (212) 438 5093; steve.wilkinson@spglobal.com | |
Stephen A Anderberg, New York + (212) 438-8991; stephen.anderberg@spglobal.com | |
Secondary Contacts: | Carin Dehne-Kiley, CFA, New York + 1 (212) 438 1092; carin.dehne-kiley@spglobal.com |
Nick W Kraemer, FRM, New York + 1 (212) 438 1698; nick.kraemer@spglobal.com | |
Nicole Serino, New York + 1 (212) 438 1396; nicole.serino@spglobal.com | |
Jon Palmer, CFA, New York; jon.palmer@spglobal.com |
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