The U.S. economy is entering a delicate transition period, moving away from the COVID-19 recovery toward slower growth, persistent inflation, renewed supply chain disruptions, and tighter monetary policy. S&P Global Ratings does not see a meaningful threat of a recession over the next 12 months and pegs the likelihood of recession at 20%-30%. Economic growth is running out of steam, evidenced by a decelerating trajectory in profit growth among speculative-grade rated companies. This corroborates our earlier view that profit margins have peaked for most of these entities. We believe supply shortages and ensuing price surges will continue into 2023. The question is how companies will cope with the ongoing margin erosions at the same time that benchmark rates are likely to rise rapidly. We believe efforts will be directed at preserving liquidity by slowing down on merger and acquisition (M&A) activities and keeping a tight rein on capital spending and shareholder distributions. This may be the case especially for 14% of the 'B-' rated companies that will fail to achieve free operating cash flow (FOCF) this year, whether it is due to operating cash burns or one-off expenses. For other entities, higher financing costs are largely cushioned by the excess cash and credit buffer that they accumulated during the pandemic.

Deep Dive Into 'B-' Rated Issuers And Their Free Operating Cash Flow

In this report, we spotlight reported FOCF-to-debt credit measures, focusing on the largest and most vulnerable constituent of the speculative-grade universe in North America--the 'B-' rated segment. We view the FOCF-to-debt ratio as often a better cash flow and payback credit measure, especially for capital-intensive companies. High working capital or capital spending lowers the cash flow available for debt servicing, sometimes causing EBITDA and funds from operation (FFO) credit ratios to miss building liquidity pressures and overstate an obligor's financial strength.

Our study of 436 'B-' rated entities shows a group median FOCF to debt of 1% in 2021, and 4% in our 2022 forecasts. The upward trajectory is consistent with a general trend toward improving cash flow generation, in tandem with a steady decline in leverage that we are seeing. We project the share of FOCF deficit will decline from 43%, to 14% in 2022, as more companies will break into sustained and healthy operating profits (see chart 1). Meanwhile, the share of entities with modest positive FOCF to debt (0%-2%) will increase to 15% from 10%, and a larger 11% expansion in the size of the 5%-10% bucket, with the biggest growth expected in the 2%-5% bucket of 15%. While surging costs and supply chain disruptions have slowed growth, they have not reversed the trend of improving profits.

Chart 1

Weak fundamental and interrupted cash flow in 2021.   Depressed free cash flows in 2021 were mostly attributable to two factors. First, from the lingering effects of the pandemic. Sectors such as airlines, cruises, and lodging still have quite some catching up to do in the COVID-19 recovery. All were gradually picking up pace last year despite setbacks from the omicron variant, and are now experiencing renewed demand and revenue growth, which should boost profitability and cash flow given generally high operating leverage in these sectors. Second, last year, a torrent of M&As and leveraged buyouts (LBOs) saddled companies with sizable transaction fees. Restructuring activities and opportunistic tack-on acquisitions have also weighed on cash flows. It may be argued that spending related to M&A and LBO is opportunistic and one-time in nature and that a decrease in risk tolerance in a downturn will cause companies to refrain from taking on these activities. They nonetheless reflected the reduced cash reality in 2021. Weak cash standing inevitably increases vulnerability to adverse economic conditions.

Future pressure points.   Further reductions in free cash flow levels could come from several pressure points, including a meaningful pullback in consumer demand, accelerated increase in benchmark rates following faster implementation of policy rate hikes especially for loan issuers, and underachievement of expected synergies and cost savings. Based on our 2022 forecasts, we expect 14% of total by count would fail to achieve positive free operating cash flow this year. The debt of these entities makes up about 12% of the total sample debt estimated at year-end 2022. While we view FOCF deficit as a sign of unsustainability, it does not signal imminent distress or default, usually due to an absence of near-term debt maturities or financial maintenance covenants, as well as sufficient near-term liquidity. Nevertheless, 'B-' entities reporting prolonged negative FOCF, without a cushion of large excess cash, are teetering on the brink of a downgrade. FOCF-to-debt metric is often cited as a downgrade trigger to 'CCC+'. In other words, we view it as one of the key differentiators between 'B-' and a lower rating. Beyond the obvious risk of not meeting debt service obligations, cash flow hardships generally result in underinvestment in research and development, as well as delays in adoption of new technology; both are detrimental to competitive position in the long run.

Our economists expect the Federal Reserve's funds policy rates to reach 1.75%-2.0% at year-end 2022, 2.75%-3.0% in 2023, from 0.25% in 2021. We also gauged speculative-grade borrowers' sensitivity to higher interest rates. Specifically, we measured the impact to our 2022 forecasts of reported FOCF and EBITDA-cash-interest-coverage after applying different magnitudes of stress to the all-in-interest costs and EBITDA margins. We find that a dual stress of 150 bps increase in interest and 5% decline in margin would edge an additional 13% of 'B-' rated issuers into the cash flow deficit category.

Scale matters.   We see scale and competitive position as the key drivers behind the diverging performance in 2022. And in that respect, we expect stresses to be most acute for companies with a vulnerable business risk profile (BRP). These companies are smaller in size: The median 2021 reported EBITDA of a vulnerable BRP is $56 million, substantially smaller than the median size of weak risk profile ($78 million), and less than a third of a company with a fair BRP ($188 million). Without scale, they have less power to set prices. Their generally weak market position may also give them no incentive for raising prices to pass on costs as they fight for market share. Moreover, smaller business borrowers lack the funding options and the lender depth that their larger peers enjoy. Loan funding is their principal source of outside capital. We find the sub-zero tail of our FOCF-to-debt 2022 forecasts has a higher proportion of entities with vulnerable BRP, of 23%, compared with 14% of the overall sample.

More sector dispersion is ahead.  The telecommunications, auto/trucks, and transportation sectors experience higher risk in the FOCF-to-debt ratio in our forecast. Telecommunications and cable companies lagged behind other sectors by a large margin. This is largely because of their high capital spending, specifically hefty investments in fiber and their 5G rollout. We expect capital expenditure to remain high for these companies in 2022. Then there are industries more sensitive to negative real wage growth that curtails discretionary spending. These sectors are cyclical and sensitive to economic recessions, such as auto manufacturing. Somewhat insulated from extreme market turbulence are industries whose near-term revenue streams are more predictable (such as software companies) or where companies have demonstrated financial policy prudence, such as oil and gas and mining and minerals.

Chart 2

Strong Profit Growth Has Overpowered Headwinds Thus Far, But We Expect Deleveraging To Slow Down

By mid-April, 853 public and private companies that we rate in the U.S. and Canada had reported financial results for calendar year 2021 (see table). This sample size is smaller than the one tracked in our previous reports due to the time lag in filing annual reports. Nonetheless, we believe it provides a representative sample of operating performance for individual rating categories for the North American speculative-grade universe. However, because the companies missing in this data set are predominantly smaller and have lower ratings, we do not include a breakdown of the results by sector or in the aggregate because these figures may be skewed.

At the end of 2021, reported EBITDA continued to build on its recovery, resulting in steady deleveraging among speculative-grade companies. On a median last 12 months (LTM) leverage basis, almost all rating categories now compare favorably with year-end 2020, and leverage of most 'BB' ('BB+'/'BB'/'BB-') and B ('B+'/'B'/'B-') category rated entities has returned to (or dropped below) pre-pandemic levels. Despite persistent challenges (constrained labor supply, erratic commodity price movements, and soaring transportation costs, for example), 'B-' rated companies cut their median LTM leverage by another 0.4x in the fourth quarter.

We expect further deleveraging in the rest of 2022, but at a slower pace. Recently, there have been signs of profit abating: EBITDA growth has gone off its recent peak. Two-thirds of companies in the sample saw gains in EBITDA in the fourth quarter, compared with 80% in the second quarter of 2021. We expect more profit margin erosions as macro headwinds blow harder.

Lastly, the 'CCC' category ('CCC+'/'CCC'/'CCC-') has had the largest credit deterioration. The median LTM leverage of 'CCC+' rated companies increased by nearly seven turns over the pandemic but has since recovered, at least on the aggregate level. The median LTM EBITDA of the segment has doubled since year-end 2020, to $68 million currently.

Growing Risks, But Stable Recovery Ratings For New-Issue First Liens

With risk appetites waning with the geopolitical uncertainties, only 200 new first-lien instruments were issued in the first quarter of 2022. This was a significant drop from the 377 in the first quarter of 2021, the busiest quarter on record for both U.S. high-yield and institutional loan issuance. The quarterly trends of our recovery expectation for first-lien new issues are measured by the average recovery point estimates of our recovery ratings (see chart 3). Average estimated recovery hovered at about the mid-60% area over the past few quarters, with a short-lived uptick in the second quarter of 2020, mainly driven by an influx of high-quality debt issued by higher-rated entities, including fallen angels of sectors most severely affected by the pandemic. In comparison, about 80% of new first-lien instruments in the first quarter of 2022 were issued by 'B' category ('B+'/'B'/'B-') rated entities.

Chart 3

The recovery ratings mix has a high concentration of '3' recovery ratings (estimated recovery of 50%-70% in a payment default), particularly in the lower half of the band (about two-thirds are estimates of 50%-55%) (see chart 4). The growing share of '3' recovery ratings reflects a balance of increasingly aggressive debt structures and the need of collateralized loan obligations (CLOs) to satisfy their collateral quality tests (for example, a maximum weighted-average recovery rate).

The strong demand for loans has led to fewer junior-lien or high-yield instruments in the debt mix. As such, loans have less debt cushion to absorb value erosion when companies are distressed. 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).

Chart 4

Related Research

• U.S. Leveraged Finance Q4 2021 Update: Are 'B-' Firms Resilient To Rate Hikes? And Leverage And Recovery Updates, Jan. 31, 2022
• Economic Outlook U.S. Q2 2022: Spring Chills, March 29, 2022