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Leveraged Finance: U.S. Leveraged Finance Q4 2021 Update: Are 'B-' Firms Resilient To Rate Hikes? And Leverage And Recovery Updates

Despite a volatile ride at the tail end of 2021, the U.S. leveraged finance market has broadly held firm with no significant disruptions. In this report, we spotlight EBITDA-to-interest and free operating cash flow (FOCF)-to-debt credit measures of 'B-' rated issuers in North America in an attempt to gauge their sensitivity to the Federal Reserve's rate hikes expected this year. Unlike higher-rated peers that utilize high-yield notes, 'B-' issuers heavily rely on floating-rate loans for external funding needs. Our analysis of 469 'B-' rated North American corporate entities indicates that despite being heavily indebted, most are resilient to rate hikes in the near term, judging by 93% having an EBITDA interest coverage ratio over 1.5x and with 70% over 2x.

Interest coverage measures can, however, overstate borrowers' financial flexibility because high capital spending lowers the cash flow available for debt servicing. Consequently, we also review FOCF to debt that often better reflects the cash flow in relation to financial obligations, especially for capital-intensive companies. The pool shows a weaker financial profile based on FOCF-to-debt ratios, with 63% having FOCF to debt below 5%. By sector, telecommunications and autos/trucks have the lowest FOCF-to-debt ratios suggesting they have less financial flexibility.

Near-Term Rate Hikes Not A Significant Threat To Interest Coverage, But FOCF-To-Debt Ratios Suggest Some Sectors Are More Vulnerable

The past decade was characterized mainly by extended periods of low interest rates and broad credit availability. In turn, corporate borrowers routinely used high levels of debt financing to support corporate actions, but low interest rates helped keep interest coverage metrics comfortable. Financial pressure from pending rate hikes is likely to be limited in the near term because many firms regularly refinance their debt to refresh liquidity, lower interest costs, and push out debt maturities.

Further, the impact on cash interest costs will be blunted because many loans have interest rate floors above current benchmark rates and/or have interest rate swaps in place. Still, higher interest rates are likely to eventually reduce cash flows, which could be problematic for firms with less financial flexibility due to high capital spending requirements. Longer term, the ability to refinance debt in a higher interest rate environment bears watching, especially if spreads increase due to the repricing of risk in a less benign credit environment.

Our study of 469 'B-' rated North American corporate entities shows a group risk profile of high indebtedness based on our calculated median debt-to-EBITDA ratio of 7.3x, 4.1% FOCF to debt, and 2.3x EBITDA interest coverage, with 78% of the entities owned by private equity sponsors. We calculated the medians of each credit measure (see charts 1 and 2) for each sector. The sectors in quadrant III of chart 1 and quadrant IV of chart 2 have a higher risk profile than that of the group average, while those in quadrant II of chart 1 and quadrant I of chart 2 are better positioned versus peers. The bubble size represents entity count, and vertical lines represent the group median.

Chart 1

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Table 1

Sector Median EBITDA Interest Coverage And FOCF-To-Debt
Org Group Entity count Median EBITDA interest coverage (x) Median FOCF to debt (%)
Aerospace/Defense 6 2.01 3.05
Auto/Trucks 12 2.14 2.91
Business and Consumer Services 53 2.46 3.98
Cap Goods/Machine&Equip 56 2.51 4.19
Chemicals 15 2.52 3.64
Consumer Products 37 2.26 4.05
Forest Prod/Bldg Mat/Packaging 17 2.58 3.45
Healthcare 65 2.06 3.32
Media, Entertainment & Leisure 59 2.07 4.44
Mining & Minerals 14 4.76 15.15
Oil & Gas 24 5.97 7.63
Restaurants/Retailing 25 2.26 4.78
Technology 57 2.18 4.45
Telecommunications 18 2.78 2.06
Transportation 9 2.60 3.40
Median (Total) 469 2.3 4.1
FOCF--Free operating cash flow.

Chart 2

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Table 2

Sector Median EBITDA Interest Coverage And Leverage
Org group Entity count Median leverage (x) Median EBITDA interest coverage (x)
Aerospace/Defense 6 7.67 2.01
Auto/Trucks 12 7.26 2.14
Business and Consumer Services 53 7.68 2.46
Cap Goods/Machine&Equip 56 6.97 2.51
Chemicals 15 6.77 2.52
Consumer Products 37 7.29 2.26
Forest Prod/Bldg Mat/Packaging 17 6.90 2.58
Healthcare 65 7.97 2.06
Media, Entertainment & Leisure 59 7.49 2.07
Mining & Minerals 14 3.90 4.76
Oil & Gas 24 2.36 5.97
Restaurants/Retailing 25 6.89 2.26
Technology 57 8.62 2.18
Telecommunications 18 5.84 2.78
Transportation 9 6.71 2.60
Median (Total) 469 7.3 2.3

Higher-risk cluster.   Autos/trucks, aerospace/defense, and the health care sector landed in the high-risk quadrant, with FOCF-to-debt ratios among the lowest in the group. Pulling down the median for autos/trucks is a small set of auto suppliers with low or negative FOCF. This includes Aludyne Inc. and Cooper-Standard Holdings Inc., both of which have been hit by lower original equipment manufacturer (OEM) production and inflationary increase in raw material costs. We anticipate both companies' FOCF to be slightly negative this year.

Telecommunications and cable companies lagged behind others on FOCF to debt by a large margin. This is largely because of their high capital spending, such as hefty investments in network rollouts and upgrades. The pandemic has shown the importance of high-speed connectivity. We expect capital expenditure to remain high in 2022 as more companies support fiber and 5G rollout. The sector's weak FOCF is offset by relatively low leverage and healthier EBITDA interest coverage. Telecom is also among the sectors least disrupted by the pandemic.

Health care ranks near the bottom on all three measures.   The potential impact could be significant as health care companies make up 14% of all the 'B-' companies, ahead of media, entertainment, and leisure (13%) and the technology sector (12%). Following a successful rollout of the vaccination program, all health care subsectors largely recovered by the end of 2021. That said, a high proportion of health care equipment companies have FOCF to debt below 2%, which is less than half of the group median of 4.1%. Excluding this subsector would increase the median to 3.4%, more in line with other industries. On the other hand, health care software and service providers are the most indebted with median leverage of 8.3x.

Technology tops the list as the most indebted sector.   The sector has long benefited from the interest of private equity firms and strategic acquirers. Lenders are less cautious about tech companies' leverage levels because their business models are often cited for their predictable and sustainable revenue. Last year was a record-crushing year for mergers and acquisition (M&A)-related loan issuance, and tech companies were the largest contributor, making up 18% of new loans by count, according to Leveraged Commentary & Data (LCD). We expect more to follow in 2022.

Higher-cushion cluster.   The oil and gas and metals and mining sectors had the strongest credit metrics, in part because they benefitted from higher commodity prices in 2021. The oil and gas sector's first-place ranking also reflects conservative financial policies. Producers in North America remain focused on generating free cash flow to meet investor demands to pay down debt and to return capital. In addition, most M&A transactions last year were funded through equity instead of incremental debt, indicating financial discipline. We expect oil and natural gas prices to remain supportive in 2022.

Similarly, metals and mining companies have focused on improving returns for the past three to five years, which support credit quality. Record low interest rates and a weaker U.S. dollar last year have also benefitted the prices of metals. We believe profits will remain strong in 2022 even though we assume prices will soften.

Most vulnerable.   Of the 469 'B-' rated companies, we identified six with negative FOCF, concerningly high leverage at above 7x, and a negative rating outlook, though all have adequate liquidity. These companies make up only 1.3% of the 'B-' population by count; and the combined $4.3 billion of first-lien term loans held by these companies is equally insignificant in the context of the $1.35 trillion leveraged loan market (par amount outstanding tracked by S&P/LSTA Leveraged Loan Index).

Liquidity.   An overwhelming majority of our 'B-' issuers have adequate liquidity. Those with weak and less than adequate liquidity make up only 2%. Liquidity levels result from easy financing conditions and, equally important, a steady desire from management teams to build a healthy liquidity buffer. Since the pandemic's trough, most companies have actively managed their balance sheets to maintain flexibility to weather down cycles. To achieve this, companies built up their cash reserve from various sources last year, including debt refinancings and extensions, initial public offerings, asset sales, and equity offerings. Further, we assess a company's debt maturity profile with its liquidity and potential funding availability. Weighted debt maturity, which measures the weighted average maturity of bank debt and debt securities (i.e., hybrid debt) within a capital structure, averages 4.8 years across the pool, signaling a relatively modest refinancing risk in 2022.

Private equity sponsor ownership.   Financial sponsor-owned issuers make up more than three quarters (78%) of the total, and leverage exceeds 7x for 86% of this group. We generally expect private equity-owned issuers to have a highly leveraged financial risk profile. In our study pool, sponsor-owned issuers have median leverage as high as 7.4x. According to LCD, sponsored issuers accounted for 85% of the total institutional loans for dividend recap in 2021.

Steady Post-Pandemic Deleveraging

For a sample of speculative-grade-rated corporate borrowers, we tracked the transition of last-12-month (LTM) EBITDA, gross debt, and leverage for the 12-month periods ended between Sept. 30, 2019, and Sept. 30, 2021. Some noteworthy trends emerged in the third-quarter financials:

  • EBITDA growth continued to outpace debt growth in third-quarter 2021, pushing median LTM leverage to a record low of 5.3x since the start of the pandemic (see table 3). This tied with the year-end 2019 level and is only slightly above 5.2x in third-quarter 2019. The continuing improvement in leverage coincided with positive rating trends in 2021. Through September 2021, speculative-grade upgrades outpaced downgrades by roughly 2.9 to 1 in the U.S. Every sector saw more upgrades than downgrades.
  • Of the 16 sectors, leverage in 13 improved in the third quarter of 2021 versus the previous quarter, led by oil and gas, which has been a bright spot recently given a strong recovery in demand and disciplined capital spending. The sector reduced leverage to 3.1x from 4.2x in the midyear reading.
  • While leverage for the media, entertainment, and leisure sector declined more than three turns in the Q1-Q3 period of 2021, it remains significantly higher than its pre-pandemic level, as is that of the transportation sector. As expected, both sectors were hammered when health protocols and travel restrictions were reintroduced late last year in response to the omicron variant. Of the media, entertainment, and leisure companies, 14% still reported negative LTM EBITDA for third-quarter 2021, while the share was 12% for transportation. By way of comparison, at the trough, about one-third (36%) of the transportation companies (i.e., airlines, railroads, trucking, air freight, and logistics) reported a LTM EBITDA deficit, and none was in the red before the pandemic.
  • Telecoms have avoided much of the pandemic distress thus far; the cumulative effect of the pandemic on sector leverage is one of the least significant among the group, having increased by less than half a turn within our observation period.
  • From a rating perspective, third-quarter 2021 saw continuing delevering trends across all rating categories (see table 2). Median LTM leverage has more than recovered in the 'BB' category. In contrast, leverage of 'B-' is now half a turn above its 2019 level of 7.6x, which is already historically high.
  • The 'CCC' category ('CCC+'/'CCC'/'CCC-') has had the largest credit deterioration. While the number of 'CCC' category-rated companies in the U.S. and Canada has declined to a 21-month low, the remaining ones are facing crushing debt loads and depressed earnings. The gap between this segment and the higher-rated entities has widened significantly over the pandemic.

Table 3

Median Gross Leverage By Rating Category
Median gross leverage (x)
Issuer credit rating* Entity count 2019Q3 LTM 2019 2020Q1 LTM 2020Q2 LTM 2020Q3 LTM 2020 2021Q1 LTM 2021Q2 LTM 2021Q3 LTM
BB+ 111 3.18 3.20 3.36 3.68 3.45 3.25 3.10 3.00 2.89
BB 121 3.25 3.30 3.45 4.02 3.92 3.74 3.74 3.20 3.05
BB- 98 3.67 3.73 4.00 4.53 4.28 3.58 3.25 2.98 2.65
B+ 144 4.76 4.81 5.24 5.60 5.24 5.28 5.04 4.52 4.36
B 232 5.38 5.54 6.27 6.70 6.44 6.50 6.22 5.75 5.69
B- 263 7.66 7.59 8.30 8.91 8.52 9.39 8.91 8.22 8.13
CCC+ 82 8.30 8.64 9.45 13.95 14.70 15.11 16.05 12.87 12.21
CCC 28 13.28 11.39 15.09 40.02 63.09 N.M.** N.M. N.M. 53.19
CCC- 4 6.85 8.14 10.65 17.54 17.30 23.39 25.44 18.28 16.00
CC 0
Total 1,083 5.23 5.25 5.88 6.54 6.39 6.33 6.10 5.44 5.34
Note: Leverage is calculated as reported gross debt over reported EBITDA, without adjustment by S&P Global Ratings. The sample in this study is rebalanced each quarter following selection criteria, as detailed in the "Data Used in This Report" section. *Rating as of Dec. 23, 2021. **Not meaningful due to negative EBITDA affecting the median leverage. LTM--Last 12 months. N.M.--Not meaningful. Source: S&P Global Ratings.

Table 4

Median Gross Leverage By Industry
Median gross leverage (x)
Industry Entity count 2019Q3 LTM 2019 2020Q1 LTM 2020Q2 LTM 2020Q3 LTM 2020 2021Q1 LTM 2021Q2 LTM 2021Q3 LTM
Better: Improved or deleveraged compared to year-end 2019 levels
Cap Goods/Machine&Equip 116 5.94 5.94 6.26 6.15 6.09 5.34 5.88 5.47 5.42
Chemicals 35 5.15 5.33 5.53 6.60 6.79 5.34 4.65 3.98 3.83
Forest Prod/Bldg Mat/Packaging 48 4.43 4.30 4.48 3.95 4.04 4.04 4.09 4.11 3.78
Mining & Minerals 45 2.98 2.78 3.22 4.20 3.62 4.18 3.70 2.90 2.35
Restaurants/Retailing 82 4.81 4.59 5.08 6.50 5.69 5.56 5.07 4.23 3.98
Real Estate 29 6.91 6.91 7.95 7.69 7.98 7.76 6.48 6.75 6.55
Technology 93 6.93 7.47 7.01 7.27 6.65 6.42 6.62 6.92 6.61
Telecommunications 42 4.47 4.84 4.74 4.63 4.62 4.57 4.63 4.78 4.52
Worse: Leverage increased from year-end 2019
Aerospace/Defense 32 3.58 4.09 4.40 5.78 5.40 5.54 5.99 5.95 5.44
Media, Entertainment & Leisure 145 5.21 5.03 6.22 8.72 8.77 9.13 9.27 6.99 6.07
Transportation 25 3.61 4.53 4.56 7.68 10.34 10.07 10.30 7.41 6.64
Leverage remained relatively flat or has returned to 2019 levels
Auto/Trucks 36 3.84 3.92 4.55 7.33 6.29 5.67 5.55 4.09 4.09
Business and Consumer Servs 91 7.31 7.16 7.33 7.86 8.19 7.87 7.48 7.41 7.10
Consumer Products 106 5.75 5.96 6.32 6.39 6.00 6.25 5.33 5.73 6.07
Healthcare 90 6.67 6.73 7.42 7.96 7.14 7.88 7.13 6.31 6.59
Oil & Gas 68 2.51 2.88 3.00 4.21 5.31 5.13 5.60 4.19 3.08
Total 1,083 5.23 5.25 5.88 6.54 6.39 6.33 6.10 5.44 5.34
Note: Leverage is calculated as reported gross debt over reported EBITDA, without adjustment by S&P Global Ratings. The sample in this study is rebalanced each quarter following selection criteria, as detailed in the "Data Used in This Report" section. LTM--Last 12 months. Source: S&P Global Ratings.

EBITDA Growth Is Decelerating

Median LTM debt rose 2% quarter over quarter in third-quarter 2021, outpaced by EBITDA, which surged 9% quarter over quarter (see chart 3).

EBITDA had been growing since late 2020, but the newest cohort suggests a loss of momentum. Two-thirds of companies in the sample saw a gain in EBITDA in the third quarter, whereas it was nearly 80% in the prior quarter. Early margin expansions centered on borrowers' cost-cutting measures, offset by raw materials, labor, and freight costs that are ratcheting up quickly amid supply-chain disruptions and labor shortages. In fact, profit margin pressures have started to show in the third-quarter financial reports: The gain in LTM EBITDA fell the most sharply in the consumer products sector, where an inability to offset inflation with pricing actions or productivity initiatives hurt profitability. We expect cost inflation to continue until a supply-and-demand balance is restored in the second half of 2022. Elevated inflation could subdue consumer demand and help restore this balance.

Chart 3

image

First-Lien New-Issue Recovery Inched Closer To 66% Five-Year Average

The chart below illustrates quarterly trends for our recovery expectations for first-lien new issues, measured by the average recovery point estimates of our recovery ratings. Average recovery point estimates have hovered around the low- to mid-60% recently, with the last quarter of 2021 continuing this trend. Fourth-quarter 2021 was the least active quarter of the year and saw a marginal improvement.

New-issue recovery expectations vary quarterly based on supply-demand dynamics and the mix of issuer credit quality during the period. The presence of 'BB' category rated issuers in the fourth quarter decreased to 17% from 21% in the prior quarter, with an average expected recovery of 74%, ranging widely from 45% ('4' recovery rating on the senior secured credit facility at Travel + Leisure Co.) to 100% ('1+' recovery rating on the secured debt of Pacific Gas & Electric Co.). In comparison, about 80% of new first liens were issued by 'B' category rated issuers, of which corporate borrowers issued about one-third with 7x-plus leverage (based on our calculated leverage).

The strong demand for floating-rate loans is keeping loan markets accommodative. Aggressive structures such as high leverage generally result in less promising recovery prospects because recovery expectations fluctuate inversely with debt leverage (which often reflects shifts in investor risk tolerance). Furthermore, we saw M&A-driven incremental borrowings increasingly weakening recovery prospects given rich valuations and synergies yet to be achieved. That said, the magnitude of quarterly swings of average recoveries has been fairly rangebound over the past five years and may not deviate significantly from prior-year levels.

Chart 4

image

Chart 5 shows the recovery rating mix. First-lien recovery ratings are relatively clustered around '3' (50%-70% recovery estimated in a payment default), with about 62% of new issuance by count in fourth-quarter 2021 falling into this category. A much smaller share (34%) of new issues was expected to recover 70% or more, which is substantially lower than expected based on historical norms with average recoveries for first-lien debt of 70% or higher. The expectation for substantial and very high recoveries is now confined to a smaller group of companies with a meaningful cushion of junior debt in the capital structure.

Chart 5

image

Related Research

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:Steve H Wilkinson, CFA, New York + 1 (212) 438 5093;
steve.wilkinson@spglobal.com
Minesh Patel, CFA, New York + 1 (212) 438 6410;
minesh.patel@spglobal.com
Analytical Manager:Ramki Muthukrishnan, New York + 1 (212) 438 1384;
ramki.muthukrishnan@spglobal.com
Research Contributor:Maulik Shah, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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