Our baseline economic forecast is for the U.S. to suffer a "slow-growth recession," with corporate borrowers bracing for a sharp reversal in business conditions in the second half of 2022 and additional headwinds in 2023. Some shifts are already underway, evidenced by the slower quarter-on-quarter profit growth in the first quarter in most sectors. In this report, we examine the factors behind our latest ratings movements into and out of the 'CCC' category and analyze credit trends such as leverage, interest coverage, and free operating cash flow (FOCF) within our U.S. speculative-grade corporate ratings portfolio. We also review the trends in first-lien recovery ratings.

Three Factors Sparked Downgrades To The 'CCC' Category

During the second quarter, we lowered ratings on 14 issuers into the 'CCC' rating category. Downgrades to the 'CCC' category ('CCC+' and lower) from the 'B' category (comprising 'B+', 'B', and 'B-') were primarily driven by three factors.

Foremost were looming debt maturities, often posing the most immediate liquidity and default risk if operating performance is weaker than expected.   A potential recession, rising rates, and investor risk-off sentiment have made it difficult for highly leveraged companies to refinance at affordable rates. The average all-in-spread of new institutional loans by 'B' and 'B+' issuers rose to 627 basis points in June, the highest reading in 10 years and up from 418 in January, according to Leveraged Commentary and Data. The sharply rising borrowing cost could make some capital structures, especially these of 'B-' issuers unsustainable. For example, we lowered our rating on CareerBuilder LLC two notches to 'CCC' from 'B-' because of narrowing liquidity buffers and the impending July 31, 2023, maturity of its first-lien term loan, which was trading about 60%-70% of par as of July 21, 2022. Financing conditions became increasingly challenging in the second quarter. In this case, we believe a payment default could occur without improving operating performance, a timely refinancing or maturity extension, or a strategic alternative such as asset sales or equity infusion. We are also concerned that in a recession scenario, liquidity could tighten further due to springing revolver financial maintenance covenants, which increases the risk of default.

The second contributing factor was the inability to pass through higher costs or delays in doing so.   Companies in this category typically already had thin margins before costs surged. Waste and recycling equipment manufacturer Wastequip LLC (downgraded to 'CCC+' from 'B-'), for example, has a stretched liquidity profile, primarily because of increased working capital requirements amid persisting inflationary pressures and supply chain constraints. Similarly, P&L Development Holdings LLC (PLD), which we downgraded to 'CCC+' in June, also faces unprecedented inflationary pressures in sourcing raw materials, including an active ingredient chemical-grade propylene (which is used to produce isopropyl alcohol and is among the most important inputs in PLD's manufacturing process). As a private-label producer and contract manufacturer of over-the-counter pharmaceuticals, PLD has little pricing power and could struggle to raise prices to offset input cost inflation.

Lastly, changing consumer preferences, though less common are equally damaging.   Technology service provider Intrado Corp. (which we downgraded to 'CCC+' from 'B-') engages in traditional conferencing and telecommunications services. Advanced and more flexible and cloud-based communications platforms such as Microsoft Teams and Zoom are disrupting Intrado's core services.

In Some Sectors, Rising Consumer Demand Prompted Upgrades From The 'CCC' To 'B' Category

Upgrades out of the 'CCC' category have been closely tied to the continuing recovery in the travel and leisure industry as consumers shift spending budgets to services and experiences and away from goods. The upgrade list in the second quarter includes:

• Resort owner and operator Playa Hotels & Resorts N.V., which we upgraded to 'B' on strong lodging demand and average daily room rates;
• Fitness club operator Fitness International LLC, which we upgraded to 'B-' on positive membership trends since all club locations have reopened); and
• Jazz Acquisition Inc., which we upgraded to 'B-' on higher commercial airlines travel volume that is increasing demand for aircraft parts.

In most cases, reviving consumer demand led to breakeven cash flow and/or a successful refinance.

Credit Statistics Downshift For Speculative-Grade Corporates

We assessed the effect of increased rates coupled with increased input costs in some speculative-grade companies' credit metrics, including leverage, profit growth, FOCF to debt, and interest coverage. Specifically, we reviewed how these metrics have transitioned over the past 12 months. The sample covers 1,056 rated U.S. and Canadian public and private companies that had reported first-quarter 2022 financials by late June.

Fading tailwinds slow profit growth

• Unsurprisingly, EBITDA didn't grow in first-quarter 2022 as much as it did in 2021 as the economy recovered from the COVID-19 pandemic. Median last-12-month (LTM) EBITDA growth fell for a third consecutive quarter, slowing to 2.8% at the end of March from 3.8% three months earlier (tables 1 and 2). That is only a quarter of last year's peak increase of 10.7% in mid-2021. More than 60% of companies in the sample saw gains in LTM EBITDA in first-quarter 2022. The share was about the same in 2021 but with more significant EBITDA growth.
• Profit growth continues to be broad-based, but sector-level momentum has contracted, and 13 of the 16 sectors we tracked registered slower growth, with seven sectors exhibiting slowing growth of 2 percentage points or more.
• Three sectors saw mild profit contractions in first-quarter 2022. Declines were most acute and persistent in the consumer products sector, indicating that supply chain and labor market constraints have squeezed profit margins. Softening consumer spending, coupled with inflation and supply chain bottlenecks, could further pressure credit quality of consumer products issuers in 2023.
• Telecom is another sector experiencing higher leverage due to EBITDA contraction. The downward shift reflects idiosyncratic challenges as a handful of small issuers navigate secular demand headwinds not experienced sector-wide. Telecom is among the sectors least disrupted by the pandemic, evidenced by its modest swings in median EBITDA.
• Oil and gas, as well as mining and minerals, benefited from favorable commodity price trends and were top year-over-year performers, with increases of 183% and 78% in LTM EBITDA, respectively. Both sectors held on to their double-digit expansions in the first quarter of 2022.
• Profit recoveries plateaued for 'CCC+' rated companies in the past two quarters.
• EBITDA may still have room to grow in 2022 at a slower pace. Our base-case economic forecast estimates U.S. GDP growth of 2% this year and 1.6% in 2023. Airlines are likely to see a solid profit rebound for the rest of 2022 based on robust pent-up demand for travel, but they are not without challenges such as staff shortages and rising jet fuel prices. Broadly, record-high inflation could dampen the outlook for cyclical sectors exposed to falling consumer confidence.

Table 1

Table 2

Leverage reduction resumed as debt growth ebbed

• Median LTM leverage ended first-quarter 2022 at 5.4x, marginally lower than 5.6x at year-end 2021 (tables 3 and 4). The median issuer in the sample grew LTM EBITDA by 2.8% (quarter over quarter) in the first quarter of 2022, while debt amounts were relatively unchanged since 2021, which we expected, given the scarcity of recent debt borrowing activities. Meanwhile, debt repayment activities, which gained traction in the second half of 2021 as companies focused on balance sheet repairing, also dwindled.
• Issuers in the 'CCC' category led leverage reduction in the quarter. Overall, 'CCC+' rated issuers shed more than half a turn (0.7x) of leverage in the first quarter after it had surged nearly six turns during the pandemic. The median leverage of 'B-' rated issuers is now 0.5x more than it was pre-pandemic.
• We believe EBITDA growth could outpace debt growth in the near term, relieving some credit strains, especially in sectors strongly rebounding from the pandemic. A few subsectors, including homebuilders and many retailers, are coming off a great year of operating performance and have built a cushion to withstand some demand softness.
• Still, five sectors saw median leverage of more than 6x--and as high as 8.2x in health care and 7.5x in technology. Building materials saw an uptick in leverage in the first quarter that was partly attributable to scale expansion through acquisitions at the expense of increased leverage and debt. Expense related to new debt issuances, mergers and acquisitions (M&A), and leveraged buyout (LBO) activities was also a key factor in delaying leverage reduction in 2021.

Table 3

Table 4

Cash flow remains a pressure point

• Free cash flow generation is a significant concern: Median LTM FOCF to debt dropped another 1.1 percentage points in the first quarter, down from 3.9% in 2021 and 7.1% the same period last year (tables 5 and 6). Except for oil and gas, all sectors compare unfavorably to year-end 2021. While liquidity generally remains adequate for most issuers, many are retreating from large investments and debt-financed shareholder distributions as they brace for demanding operating conditions.
• Given the high volume of transactions last year as a result of favorable financing conditions, FOCF was depressed in 2021 by sizable one-time transaction fees associated with M&A and LBOs, and to a smaller extent, opportunistic bolt-on acquisitions. We expect some improvement in FOCF absent these costs.
• 'B-' rated issuers are feeling the pinch as their median FOCF to debt plunged further into negative territory in the first quarter. About 9% or 24 issuers rated 'B-' within our sample have a negative rating outlook, and almost all of them exhibit persistent negative FOCF, making them downgrade candidates in the absence of improved cash flow and a sufficient excess cash cushion. Support from sponsors in the form of capital injections served private equity-owned issuers well during the past downturn, but this support may not recur.
• The oil and gas and mining and minerals sectors have the best-positioned FOCF-to-debt ratios, followed by restaurants, retailing, and technology. Many retailers performed well in 2021, raising prices to offset material, labor, and freight cost inflation, though conditions are shifting quickly for many companies.
• The real estate sector lagged behind others with a negative 6.6% FOCF-to-debt ratio in the first quarter. The sector's consecutive declines, however, are primarily by companies' choice. The robust housing demand during the pandemic delivered one of the best years for homebuilders and developers. As a result, inventory (of land, homes, and communities for sale) declined faster than expected. These companies have spent more than usual on land and development to replenish their inventories. That said, rising mortgage rates are slowing demand for new homes.

Table 5

Table 6

EBITDA interest coverage was resilient in the first quarter, but higher interest costs are pending

Interest coverage is still benefiting from EBITDA growth tailwinds and limited effect from higher interest rates through the first quarter, and it improved to a healthy 3.4x at the end of March 2022. A decelerating economy has not significantly changed the LTM figures thus far. We expect the rapidly rising benchmark rates and widening credit spreads to bite deeper in 2023. This could have a large impact on the health care and technology sectors, both of which are most levered and hence weakest in interest coverage. Slowing earnings growth will make it much more challenging for them to maintain interest coverage levels (and put further pressure on free cash flow).

Table 7

Table 8

First-Lien Recovery Expectations Remain Below Historical Levels

Volatility and risk aversion are hurting deal volumes in the leveraged finance market. Second-quarter 2022 was one of the quietest periods in new issuance, with a total of 152 new issues. Average recovery expectations for first-lien debt issued in the quarter, as measured by our recovery point estimates that are part of our recovery rating, were unchanged from the prior quarter at 64% (chart 1).

First-lien recoveries declined over the past decade relative to the historical average. Data collected from North American companies that exited Chapter 11 bankruptcy showed actual recoveries of first-lien debt averaged 78% before 2020 (2008-2019), and 68% from 2020 to second-quarter 2021). Aggressive structures led by high secured leverage and little junior cushion have diminished first-lien recovery prospects.

New-issue recovery ratings often fluctuate with shifts in investor risk tolerance, as reflected in the mix of borrower quality. About 20% of first-lien debt instruments in second-quarter 2022 were issued by 'BB' category-rated entities, up from 14% in the prior quarter, reflecting lender preference for higher-quality assets. Recovery is positively correlated with issuer credit rating. The average recovery estimate of 'BB' category issuers was 74% in the second quarter, notably higher than the 60% average of 'B' category issuers.

Chart 1

We continue to see a high concentration of '3' recovery ratings (indicating an estimated recovery of 50%-70% in the event of a payment default), which composed two-thirds of the total. The growing share of '3' recovery ratings reflects a balance of increasingly aggressive debt structures and the need for collateralized loan obligations (CLOs) to satisfy their collateral quality tests (e.g., a maximum weighted-average recovery rate). As there is a high concentration of '3' recovery ratings among first-lien debt, credit rating mix has also shifted toward lower-rated issuers: Issuers rated 'B' and below now represent more than 60% of our speculative-grade credit portfolio. The expansion was led by 'B-' rated issuers, which now account for about 26% of all speculative-grade issuers.

Chart 2

Related Research

• U.S. Leveraged Finance Q1 2022 Update: Free Operating Cash Flow Is Put To The Test As Headwinds Blow Harder, May 3, 2022
• Recovering From COVID-19: Why The Timing Of Bankruptcy And Emergence Matters For Debt Recovery, Feb. 7, 2022