Despite supply-chain constraints and a resurgence in the pandemic with the Delta variant, market confidence remained strong during the third quarter, with participants largely optimistic about the near and medium terms. Such exuberance might be at least partially warranted, as EBITDA among U.S. and Canadian corporates has been growing markedly since the start of the year. The extremely benign default environment and the low cost of funding have also made companies and lenders more comfortable with high leverage.

Against this macroeconomic backdrop, activity in leveraged lending is brisk. Loans were launched to fund M&A and LBOs at a record pace despite exceptionally rich valuations. This reflects the low interest rates and fierce competition among private equities. Dividend recap volumes have already set a new annual record, as has issuance in the U.S. leveraged loan market according to Leveraged Commentary & Data (LCD).

In this report, we look at the effect of the pandemic and the ensuing recovery on corporate borrowers' leverage and cash reserve. In particular, we tracked their trends for a rolling universe of speculative-grade companies for the 12-month periods ended between Sept. 30, 2019, and June 30, 2021.

Leverage Returned To (Or Dropped Below) Pre-Pandemic Levels For Most Sectors

Some noteworthy trends emerged in the second quarter:

• After 12 months of consecutive declines, the median leverage of speculative-grade borrowers has returned to--or improved from--2019 levels overall. EBITDA increased for nearly 80% of companies in the sample. This more than offset the resurgence in debt borrowing and drove down the overall median LTM leverage to 5.3x by the end of second-quarter 2021 (see Table 1).
• Companies attributed their recent EBITDA margin expansions to a variety of factors--such as their ability to push through price increases, tight cost controls, and strong inventory management--that enabled them to meet pent-up consumer demand. These factors, among many others, allowed companies to fend off margin compression from rising freight and raw material costs.
• The chemicals and consumer products sectors are leading the way in deleveraging. Both have capitalized on the rebound in the U.S. economy and spending levels, and consequently, their leverage dipped to the lowest levels since Q3 2019: 4.0x for chemicals and 5.0x for consumer products. In Q2 2021, chemical companies reported a 13% quarter-over-quarter increase in median LTM EBITDA, up 31% from the same period a year ago.
• The auto/trucks sector--which includes vehicle manufacturers, retailers, and parts and equipment suppliers--is also reaping the benefits of strong consumer demand and higher prices on more profitable light trucks. However, OEM supply is still hampered by semiconductor-related chip shortages. The sector saw solid (26%) quarter-over-quarter LTM EBITDA growth in the second quarter, either organically or through acquisitions. The result was a quarter-over-quarter decline in leverage in excess of 1.5x in second-quarter 2021.
• The effect of the semiconductor supply shortage has rippled far and wide, affecting a broad range of end markets, such as auto and technology hardware. We believe the demand/supply imbalance will likely persist until at least the end of this year (and through a good part of 2022 for certain products). While semiconductor manufacturers have plans to scale up, it will likely take years for production from new facilities to provide relief to the current chip shortage.
• Technology and telecommunications are among the sectors least disrupted by COVID-19, as demonstrated by them having the smallest swings of median LTM leverage within our observation period.
• In contrast, it remains a volatile time for the transportation sector and airlines. The LTM EBITDA of the 10 airlines in our sample fell an average of 150% year-over-year in 2020. Moreover, only two of the 10--Alaska Air Group Inc. and Allegiant Travel Co.--recorded positive LTM EBITDA in Q2 2021. Both are predominantly domestic carriers. Unlike intercontinental travel, which remains subdued, domestic air travel accelerated throughout Q2 2021, leading to a comparatively strong summer for airlines serving that market. We expect the momentum to taper off to some extent in the fourth quarter due to the industry's typical seasonality, alongside an increase in COVID-19 cases that appears to be affecting bookings. Nonetheless, our ratings on U.S. airlines now have stable or positive outlooks, though they remain one to four notches below pre-pandemic levels.

Table 1

Ratings In The 'CCC' Category Are On The Mend

So far in 2021, we've upgraded a significant number of 'CCC+' rated entities, predominantly to a 'B-' rating. These actions reflected both their improved liquidity and revenue rebound. Luxury department store NMG Holding Co. Inc. (Neiman Marcus) is one example: We raised the rating to 'B-' from 'CCC+' after the company fully paid down a sizeable draw under its asset-based lending facility. Its enhanced liquidity and better-than-expected performance drove the upgrade.

While the size of the 'CCC' cohort is shrinking from the peak, the remaining 'CCC' rated companies are facing high debt loads. The gap between this segment and higher-rated entities has widened significantly since the pandemic.

Our analysis shows the median leverage of companies in the 'B-' rating level now sits half a turn above the 2019 level, which was already historically high. 'B-' rated companies are generally sensitive to interest rate hikes, as debt loads could be hard to manage if rates rise faster than expected. Despite adequate liquidity in the near term, they generally lack a sufficient cushion to weather protracted revenue disruptions.

Table 2

EBITDA Is Increasing, But Demand Reversion And Debt-Funded Acquisitions Could Delay Any Rating Improvements

Examining the leverage measures reveals that the moderation was fueled by EBITDA growth more than debt reduction. Median LTM EBITDA has surpassed the 2019 level after growing 28% in the first half of 2021. More encouragingly, just about one-third of the companies in the sample have had consecutive growth for every quarter since the second half of 2020.

However, the pace of EBITDA growth might have peaked in some areas. In another recent example of us raising a rating to 'B-' from 'CCC+', apparel retailer Jill Acquisition LLC's performance has rebounded with good profit margins. However, we believe expanded profitability will somewhat reverse over the next year because of increased freight and supply-chain costs stemming from pandemic disruptions. This--combined with our expectation for normalizing retail demand--suggests performance will likely decelerate in the second half of 2021 and into 2022. As economic growth eventually returns to normal levels, we expect more instances where EBITDA growth proceeds at a less robust rate in the quarters ahead.

Furthermore, debt levels began to rise this year, offsetting EBTIDA growth momentum. The resurgence in borrowing was largely driven by M&A and dividend recaps, which are putting pressure on companies' credit measures. Building materials distributor Specialty Building Products Holdings LLC issued a new first-lien term loan in October to finance two bolt-on acquisitions. We project this will cause the company's debt levels (with our adjustments) to more than double from a year ago and drive up adjusted leverage by about two turns over the next 12 months. In this example, while business conditions remain favorable, the debt-financed acquisition will likely delay the potential improvement in credit quality by a few quarters.

In another case, TAMKO Building Products LLC pursued a $250 million add-on to the first-lien debt to fund a dividend distribution to the owners. Prior to the add-on, company had been deleveraging, helped by solid demand and strong earnings expectations for the near term. However, the incremental debt reversed this trend and depleted some of the cushion that had been built up on the credit measures. As a result, we now expect adjusted leverage to be a turn higher. In our view, TAMKO's credit quality is now more susceptible to a potential downturn in business conditions.

Chart 1

Ample Cash Lingers

The median size of cash holdings (including cash equivalents and short-term investments) has doubled since third-quarter of 2019 and has stayed elevated (see Chart 1). More recently, companies have built up cash balances from a variety of sources, including initial public offerings, asset monetizations, and equity offerings.

In our sample, 58% of the cash holdings reside with entities rated in the 'BB' category, which make up 30% of the sample by entity count. This disproportionate share is unsurprising, as higher-rated entities are typically larger in size and have prudent risk management and stronger liquidity positions. Only a small fraction (3%) of cash is held at entities rated in the 'CCC' and 'CC' categories, which collectively account for 11% of the sample. The mismatch suggests a tangible risk of a near-term liquidity squeeze.

Transportation tops other sectors with the largest amount of cash holdings, but that is concentrated in the hands of three major U.S. airlines: United Airlines Holdings Inc., American Airlines Group Inc., and Delta Air Lines Inc. Combined, they held $54 billion of cash at the end of Q2 2021. Elsewhere, the media, entertainment, and leisure and technology sectors are also rich in cash, with 16% and 13%, respectively, of total cash holdings. Among tech companies, 70% hold more cash now than they did in 2019.

Pandemic-battered cruise operator Royal Caribbean Cruises Ltd. and motion picture exhibitor AMC Entertainment Holdings Inc. still had negative EBITDA for the 12-month period ended June 30, 2021. Nevertheless, our analysis shows both companies have plentiful cash on hand due to repeated trips to the high-yield and equity markets. Although that access to external funding was costly, having it proved pivotal last year when operations ground to a halt.

As stabilizing operations reduce the need for liquidity buffers, bigger emphasis is being put on how companies use their cash. We see companies increasingly favor acquisitions for growing size, and currently favorable funding rates will continue to encourage aggressive financial strategies such as sending large cash payouts to shareholders. Decisions around financial policy play a big factor in influencing the potential direction of rating actions, particularly for borrowers on the cusp between two ratings.

Chart 2

First-Lien New-Issue Recovery Remains At The Lower Half Of Its Multi-Year Range

New-issue recovery expectations on first-lien debt vary quarterly based on supply/demand dynamics and the mix of issuer credit quality during the period. There was a predominance of new issues from 'B' category entities in the third quarter (77% by issue count), which compares with 21% from 'BB' entities. Average recovery estimates have hovered around the low- to mid-60% area in recent years, with the latest cohorts only drifting marginally higher from their historical lows (see Chart 3). The quarterly average slumped to an all-time low of 62% at the end of 2020 after peaking at 71% in the second quarter.

Notable among them was the $7.8 billion cross-border first-lien term loan issued by Mozart Debt Merger Sub Inc. (which does business as Medline Industries). According to LCD, since the Global Financial Crisis (GFC), this was the fourth-largest institutional loan for LBO financing and the largest LBO deal when considering the total financing of $14.77 billion. We assigned a '3' recovery rating to the term loan, reflecting our expectation for meaningful (50%-70%; rounded estimate: 50%) recovery. (Our averages are not skewed by the Medline tranche, as they are issue-weighted as opposed to volume-weighted.)

The strong demand for institutional loans could lead to a continuation of accommodative loan markets, with more aggressive structures (high leverage). This generally results in less-promising recovery prospects because recovery expectations typically fluctuate inversely with debt leverage (which often reflects shifts in investor risk tolerance). That said, the magnitude of quarterly swings of average recoveries has been fairly rangebound over the past four years and might not deviate significantly from prior-year levels.

Chart 3

Breaking down the trends by rating category, recovery ratings for first-lien debt are fairly clustered around '3' (50-70% recovery estimated in a payment default), with about 65% of new issuance by count falling into this category in third-quarter 2021. Within this category, recovery estimates migrate incrementally to the lower end as borrowers pursued add-on term loans that further diluted recovery for the first lien.

A much smaller share (21%) of new issuance was expected to recover 70% or more, which is substantially lower than would be expected based on historical norms of average recoveries for first-lien debt of 70% or higher. The expectation for recoveries of 70%-plus is now confined to a smaller group of companies that still have a meaningful cushion of junior debt in the capital structure.

Our study of U.S. corporate debt recoveries finds that about two-thirds of the first-lien debt of the companies that defaulted between January 2008 and June 2020 achieved 70% plus recovery. We attribute the decline in first-lien recovery expectations to the influx of highly leveraged new issuers in recent years and an increasing reliance on first-lien debt, including first-lien-only debt structures and a shrinking cushion of junior debt where it still exists.

Chart 4

Related Research

• Airports Face A Long Delay To Global Air Traffic Recovery, Sept. 24, 2021
• U.S. Leveraged Finance Q2 2021 Update: Credit Metric Recovery Shows Sector, Rating, And Capital Structure Mix Disparities, July 20, 2021
• Industry Top Trends Update: Autos North America, July 15, 2021
• Credit FAQ: Latest Views On Hot Tech Topics--Semiconductor Supply Shortage, Inflation, And Big Tech Regulation, July 9, 2021
• COVID-19 Heat Map: Pent-Up Demand And Supply Shortages Further Improve Recovery Prospects For Credit Quality, June 8, 2021
• From Crisis To Crisis: A Lookback At Actual Recoveries And Recovery Ratings From The Great Recession To The Pandemic, Oct. 8, 2020