New issuance rose sharply in 2021, with investors ploughing fresh liquidity into almost all issuers that had a need for it--including funding dividend distributions, backing new leveraged buyouts (LBO) and other mergers or acquisitions (M&A), and propping up liquidity for issuers in difficulty. Credit quality stabilized, with a decrease in negative outlooks across all rating levels and a more promising upgrade trend. Issuers, sponsors, and investors alike seem to support sacrificing deleveraging prospects for increased financial flexibility over the next one to two years, which is evident in robust buildup of cash on balance. Concerns over macroeconomic growth prospects and inflationary pressures are kept in check through furlough schemes, dovish monetary policy, and continued vaccine rollout across the eurozone. Trends in credit stabilization, cash on balance, and liquidity scores point to potentially lower nonpayment defaults. However, we cannot full eliminate the possibility of debt restructuring in sectors that are highly dependent on the lifting of travel restrictions across Europe, expected from June.

New First-Lien Speculative-Grade Issuance

The average recovery rate held steady despite record issuance

New first-lien, or senior secured, tranches contributed €52 billion to total European speculative-grade issuance in the first quarter of 2021. The average expected recovery rate for new first-lien debt bounced back to 57% (see chart 1), driven by an influx of new ratings in the single-B rating category. An increase in first lien leverage to well above 5x was mitigated by robust equity cheques in new transactions, debt-funded M&A increasing underlying asset value, and issuers with approaching maturities utilizing subordinate debt to refinance (e.g. Douglas GmbH). Receptive and liquid markets also saw an increase in dividend recapitalization, through stretched leverage (e.g. Xella International S.A. and Foncia Management), which led to a downward revision in expected recoveries by approximately 5%.

Chart 1

'B' category issuers dominated

Issuers rated in the 'B' category raised €41 billion in new speculative-grade first-lien debt in the first quarter, or 79% of the total (see table 1). The average tranche size was €550 million, compared with €465 million during 2020. The pandemic showed that larger debt tranches, on average, tend to be more liquid in secondary trading and have more stable pricing. In other words, secondary liquidity has proven instrumental in investors reallocating capital away from challenged assets, therefore larger tranches have found solid (if not, preferred) reception by investors both in the loan and high-yield debt markets. Sponsors have also responded in kind, providing a steady inflow of sizable LBO transactions during this quarter.

The return of 'B' rated issuance was supported by buoyant secondary markets, which, fueled by benign monetary policy and positive tailwinds from the COVID-19 vaccine rollout in most European countries, have reverted to pre-pandemic pricing levels.

Table 1

European First-Lien Speculative-Grade Debt Analysis

The average recovery rate has stabilized

As of March 31, 2021, S&P Global Ratings rated €804 billion equivalent of speculative-grade debt from over 700 European obligors. Rated first-lien senior secured debt amounted to €535 billion equivalent, including committed revolving credit facilities (RCFs) and defaulted debt. The average recovery rate on this debt at quarter-end was 57% (see chart 2).

Chart 2

A recovery rating of '3', indicating our expectation of a recovery rate of 50%-70%, remains the most common recovery rating for first-lien speculative-grade debt in Europe (see chart 3). Our expected recovery rate remains on average much lower than the actual average first-lien recovery rate of 73% over 2003-2009 (see "European Corporate Recoveries Over 2003-2019: The Calm Before The COVID-19 Storm," published Aug. 5, 2020, on RatingsDirect).

Recovery prospects differ widely by sector

By sector, telecoms is the largest contributor to rated European speculative-grade senior secured debt, followed by media and entertainment, health care, and consumer products (see chart 3). These sectors have broadly stable recovery outcomes, with a standard deviation of 5%. Capital-intensive sectors such as automotive, transportation sectors, oil, mining, and capital goods exhibit the most variability from mean values. This is because of the amount of auxiliary facilities to fund working capital needs (which we often consider as priority debt), pension-liability deficit adjustments (particularly in issuers based in German-speaking countries), and excessive leverage, as these sectors faced challenging conditions even prior to the pandemic.

Chart 3

The €36 billion increase in the total first-lien rated universe over first-quarter 2021 stems from senior secured debt with expected recoveries between 50% and 60% (see chart 4).

Chart 4

Telecoms and technology issuers remained the most prominent in the 60%-65% recovery buckets in the first quarter of 2021, with over €105 billion of outstanding debt representing 42% of total rated first-lien debt within that recovery range. Health care and consumer products remained the most prominent in the 50%-55% recovery bucket, with over €63 billion of rated first-lien debt (or 35% of total outstanding).

Loans fare better than bonds in the recovery stakes

Loans, on average, have higher expected recovery rates than bonds (see table 2). For issuers rated 'B+' or below, this is because of the presence of a super senior RCF in bond-only capital structures. For 'BB' category issuers, reasons include higher leverage on average for those tapping the high-yield capital markets, and frequent presence of factoring or securitization facilities, which we deem to have priority at default.

That said, 'BB' category issuers with first-lien debt are rare as they predominantly resort to unsecured debt to finance their capital needs. Approximately two-thirds of all debt rated in this category is unsecured, with 'BB' and 'BB-' rated debt carrying an average expected recovery rate of 56%, whereas unsecured debt rated 'BB+' has an average expected recovery rate of 63%.

Table 2

Improving Credit Quality And Liquidity Alleviates Default Risks

Negative rating actions in Western Europe peaked in the third quarter of last year. In the final quarter of 2020 and first quarter of 2021, we saw both increasing upgrades and stabilization of outlooks across the rating spectrum, particularly in the 'B' category rated issuers.

'B' rated issuers increased

Given new issuance and upgrades, 'B' rated issuers now account for 34% of the rated universe (versus 31% at the peak of the negative rating actions during third-quarter 2020, though still far off the 40% of total at year-end 2019). The number of 'B-' and 'CCC+' and below rated issuers was unchanged versus the previous quarter, at 125 and 62, respectively. This corresponds to 20% and 13% of all speculative-grade issuer credit ratings (see chart 5).

Chart 5

First-lien outstanding debt per rating category increased during the first quarter

First-lien debt rose both by nominal amount and percentage of the total issuance (see chart 6). First-lien debt rated 'B' increased by €24 billion, largely due to sizable, debt-funded M&A add-ons and new issuer LBOs as well as dividend recaps with increased first-lien leverage of established issuers. 'B-' rated first-lien debt increased by €4 billion, driven primarily by new issuance in the software and high technology sector and only one downgrade. The amount of first-lien debt rated 'CCC+' or below continued to reduce by a further €4 billion, reflecting a higher proportion of upgrades than downgrades from that rating bucket. Debt rated 'D' or 'SD' (default) decreased sharply to €1 billion compared with €4.4 billion in third-quarter 2020 and €7.1 billion in fourth-quarter 2020.

Chart 6

The negative bias trend has reversed sharply

The rise in 'B-' and below rated issuers with a negative outlook in 2020 reversed sharply in the last quarter, pointing to stabilization in outlooks across the rating spectrum and potentially, a continuing improvement in the credit quality of the speculative-grade ratings universe over the next few quarters (see chart 7).

The fastest rebound and stabilization was observed in the 'B' category where more than one-third of the negative outlooks outstanding in the previous quarter were revised to stable during the first quarter of 2021.

Western European issuers with a negative outlook numbered 200 at the end of first-quarter 2021. This is 59 issuers (23%) lower than the peak in third-quarter 2020. We include the European Union, Nordics, and the U.K. in these figures, but exclude infrastructure and financial services issuers.

Chart 7

Sector impact is not uniform

Five sectors have contributed over half of the downgrades since the beginning of 2020 and account for more than half of the negative bias. The media, entertainment, and leisure; consumer products; auto; transportation; and aerospace sectors are responsible for half (106 issuers) of the total 200 negative outlooks currently outstanding, yet they account for just 17% of all speculative-grade rated issuers in the region (see chart 8). These issuers continue to be vulnerable to further negative rating actions and have not seen rating stabilization to the extent seen in other segments.

Chart 8

Liquidity and financial flexibility trump deleveraging

Though overall credit metrics have remained broadly similar to year-end 2019, the conclusion dramatically changes on a sector-by-sector basis. The segments which saw the greatest sensitivity to the pandemic and macroeconomic downturn--such as transportation, aerospace, entertainment and leisure, retail, and oil--have exhibited an increase in weighted debt-to-EBITDA leverage metrics by 1.0x-2.5x. We expect a near-full reversion to 2019 levels across all affected sectors by year-end 2022, with the exception of transportation, oil, and entertainment and leisure, where risks to an uninterrupted path to recovery still remain.

Table 3

Of the 551 rated issuers in the speculative-grade universe at first-quarter end, only 63 issuers had liquidity assessment scores of "weak" or "less than adequate," or 11% of the total. Our liquidity assessment is based on a forward-looking view of whether sources of funds (including committed bank lines) exceed the necessary uses of funds (including refinancing of maturing debt) over the next two years. The weakest two scores on the scale of five available are indicative of insufficient funds and point to a potential nonpayment default in the absence of new debt or equity financing available.

The overwhelming majority of issuers that had a liquidity score of "less than adequate" or weaker were rated 'B-' (17 issuers, or 2% of the total) and 'CCC+' or below (41 issuers, or 9% of total). Only 15 issuers were rated 'CCC' or below (3% of total), indicating our expectations of default for the same within the next 6-12 months. This leads us to conclude that even severely affected credits have addressed liquidity needs to weather any turbulence, at least until the end of 2021.

Most companies adopted conservative financing strategies during the pandemic, resulting in a buildup of cash and short-term instruments on the balance sheet, which has come from a mix of improved performance and increased debt and liquidity lines.

The average cash balance carried by speculative-grade issuers was €460 million as they entered 2021. This was 28% (or €100 million) higher than the amount outstanding at the end of 2019, though most of the cash buildup was observed at the 'BB' category level. 'B' rated and below companies saw more modest increases in average cash on hand by 21% (€32 million) to on average, €167 million cash on balance.

Virtually all issuers rated 'B' and below increased their cash on hand balances compared with 2019, pointing to a receptive debt investor-base to finance activity, even for challenged companies. These trends were also evident in the U.S. (see "U.S. Leveraged Finance Q1 2021 Update: As Issuers And Investors Collaborate To Keep Markets Active, Where Does The Excess Cash Go?", published May 5, 2021, on RatingsDirect).

The combination of receptive and liquid debt market investors and robust cash balances may lead to fewer nonpayment-related defaults in 2021 and continue the trend of consensual, technical restructuring going forward. Nevertheless, debt write-downs remain a risk over the short-term horizon, particularly in sectors exposed to social-distancing measures and travel restrictions, as they will be vulnerable if expectations of a swift return to summer activity do not materialize as planned.

Upgrades beat downgrades by three in the first quarter

There were 18 upgrades in the first quarter, continuing the trend from the fourth quarter, with major sectors being consumer products, high tech, and chemicals (see chart 9). Of these, five were due to better performance than expected following the initial wave of the pandemic. In addition, we upgraded five issuers from default following their emergence from restructuring.

We continued to see fallen angels (downgrades to speculative grade from investment grade), albeit at a reduced pace, with three in the first quarter, bringing the total since the start of 2020 to 23.

Chart 9

Preemptive restructuring continues, but at a slower pace

We downgraded six issuers to 'D' (default) or 'SD' (selective default) in the first quarter. All were from 'CCC+' category or below prior to the downgrade.

Half of the defaults were companies with stretched liquidity and severely affected operations during 2020. They involved an element of debt write-off in exchange for equity, coupled with new super senior loan issuance or equity injection by the sponsors in order to prop up liquidity over the next 12 months. The other half involved maturity extension, or substituting cash for payment-in-kind interest, which we viewed as distressed exchanges, even though they were agreed by lenders.

Private equity owners have largely been supportive of their issuers through capital injections, either as debt or equity. As a result, the behavior risk embedded in loose documentation terms regarding priming existing lenders has not materialized.

If lockdowns across continental Europe continue to be extended beyond June, issuers and sectors that were relying on a big summer revival may see their liquidity come under pressure. We expect the prevalence of furlough schemes throughout 2021, continuing abundance of liquidity in debt markets, and an appetite for yield will provide a resilient backdrop for the speculative-grade universe to weather the storm. However, the continuing dovish monetary policy stance by the European Central Bank and some reversion to economic growth without runaway inflation will be crucial, and these remain key risks going forward.

Related Research

• U.S. Leveraged Finance Q1 2021 Update: As Issuers And Investors Collaborate To Keep Markets Active, Where Does The Excess Cash Go? May 5, 2021
• European Corporate Recoveries Over 2003-2019: The Calm Before The COVID-19 Storm, Aug. 5, 2020