The rise of debt service costs and deceleration of profit growth led to more credit issues for U.S. corporates with an uptick in negative rating actions, especially among borrowers at the lower end of speculative grade. To provide context in this report, we examine the credit metrics for the 12 months before downgrades to 'B-' and the 'CCC' category (CCC+/CCC/CCC-) as well as for upgrades from the 'CCC' category. We took these actions between the start of 2022 and mid-March 2023.

We also analyze use of cash in 2022. Despite significant market volatility and economic and business uncertainty, dividends and share repurchases accelerated for companies rated 'B+' and higher by deploying the solid cash reserves accumulated following the strong post-COVID-19 rebound. Finally, we continue to track trends in recovery estimates for first-lien new issues and the credit patterns of North American speculative-grade corporate borrowers dating to the pre-pandemic year of 2019.

Here, access all the charts and tables in an interactive format:

'B-' Downgraded To The 'CCC' Category

We identified 87 U.S. and Canadian corporate entities that we downgraded from 'B-' to the 'CCC' category between Jan. 1, 2022, and mid-March 2023, including 58 private equity owned companies. Chart 1 compares the key credit metrics of these entities in the 12 months leading up to the downgrade against those that remained rated 'B-' (hereafter the 'B-' static cohort) in the same period. Specifically, we looked at the median reported leverage (total gross debt to EBITDA), EBITDA interest coverage, and free operating cash flow (FOCF) to debt. We illustrate the medians of the two groups.

Near-term liquidity or sustainability of capital-structure-related concerns typically drive our assignment of 'CCC' category ratings, which reflects at least a 1-in-2 likelihood of default. Accordingly, the downgrade triggers and analysis often focus on free cash flow generation, interest coverage, current and near-term debt maturities, and/or the sustainability of the capital structure over the mid- to longer term.

Median leverage for the companies downgraded to the 'CCC' category shot up to 15.5x as EBITDA all but dried up before the rating action. This decidedly exceeds the already high 8x for the 'B-' static cohort. While FOCF languished in the red for both cohorts, the severity and persistence of negative cash flow were often key downgrade considerations. When concluding that a company has an unsustainable capital structure, cash flow shortfalls could be viewed as structural, meaning it's not a momentary setback that will likely be resolved in the near future. In fact, we expect cash uses will eventually exhaust the company's liquidity. Comparing the two ratings categories, we believe companies rated 'B-' have room to enhance liquidity by scaling back on capital spending or improving operating performance, while we would not view this as a viable option for companies rated in the 'CCC' category. Absent a substantial business and economic recovery, 'CCC' rated companies will need to raise external capital to shore up liquidity and/or refinance pending maturities to avoid a near-term cash shortfall. Syndications are tough to execute in today's risk-off environment given the general sentiment.

We estimate that only 19% of 'B-' rated entities employ interest rate hedges (based on a random sample of 173 speculative-grade issuers, from the report "New Study Finds U.S. Speculative-Grade Issuers Most Vulnerable To Higher-For-Longer Interest Rate Environment", published March 27, 2023). With the step-up in the U.S. federal funds rate, companies with EBITDA interest coverage below 1x (generally observed for 'CCC' category entities and the level generally associated with distress) will likely increase through 2023.

Chart 1

Weaker-than-expected operating performance was often cited as the driving factor behind deteriorating financial metrics for downgrades. Other business downgrade drivers are idiosyncratic in nature: for example, delayed projects, springing covenant breaches, and sizable capital expenditure (capex) leading to a funding gap. Our economists forecast a shallow recession in the U.S. with modest GDP growth of 0.7% in 2023 and 1.2% in 2024. Furthermore, we expect a federal funds rate of 4% (or higher) until late 2024, which lowers odds of a substantial recovery in credit metrics or business conditions.

'B' Downgraded To 'B-'

Moving up the credit rating scale, companies rated 'B' generally are better positioned than those rated 'B-' to withstand less favorable operating conditions or a sustained rise in debt service costs. This resilience generally reflects relatively lower leverage, higher cash balances, more resilient business models, or less sensitivity to higher interest rates. For example, we estimate that for 'B' rated companies, roughly 37% employ interest rate hedges and exposure to floating rate debt represents about 77% of their debt on average. For 'B-' rated companies, roughly 19% employ hedges and 90% floating-rate debt, respectively, based on a sample of 173 speculative-grade issuers). Pressure that could lead to a downgrade from 'B' to 'B-' may stem from deteriorating profitability, willingness to take on incremental debt, or insufficient capacity to reduce leverage following acquisitions. We expect companies to adopt a more disciplined approach in light of economic pressures and uncertainty during a downturn.

We noticed a rapid deterioration of credit quality of companies downgraded to 'B-'. Their median leverage of 9.8x was almost double that of the 'B' static cohort, while their EBITDA interest coverage was nearly halved. Additionally, their FOCF to debt underperformed the 'B' static cohort by more than six percentage points. These findings highlight the weaker financial performance of entities downgraded to 'B-' from 'B', although actual downgrades (and rating triggers) primarily reflect our forward expectations.

Judging by the median, these downgraded 'B-' issuers have collectively performed even worse than the existing 'B-' credits in terms of leverage (9.8x versus 8x), interest coverage (1.5x vs. 1.9x), and FOCF to debt (negative 4.9% versus negative 1.3%, comparing chart 1 and chart 2). The possibility of a negative trend in ratings suggests that enduring industry headwinds or secular decline would influence credit quality of downgraded 'B-' entities, leaving these companies vulnerable to further downgrades if they cannot alleviate these pressures. Our base-case assumption of a shallow recession suggests that their leverage will likely remain high over the next 12 months due to a weaker economic backdrop.

Chart 2

'CCC' Category Upgraded To 'B-'

We identified 41 corporate entities that we upgraded out of the 'CCC' category to 'B-' since the beginning of 2022, with 11 (27%) from the media, entertainment, and leisure sector, followed by five (12%) in either oilfield services or oil and gas exploration and production. Median credit metrics are illustrated in chart 3 alongside those for companies we kept in the 'CCC' rating category--the 'CCC' static cohort, which excludes companies that we downgraded to or upgraded from 'SD' (selective default) during the same period. Depending on company-specific attributes such as end-market profile and seasonal patterns, the range exists on both sides of the median is fairly wide. However, in general, 'CCC' category companies that we upgraded have taken steps such as refinancing, extending maturities, or selling assets to repay debt, which we viewed as positive developments that reduce the risk of default. Additionally, improving demand in no small part helped their bounce-off from the bottom rating tier. For example, apparel, dining out, business aviation, and our favorable view of commodity prices each have a unique credit story to tell.

As chart 3 also shows, the bar is set high to some extent for us to upgrade an 'CCC' entity. An uptick in revenue or a successful amendment of a covenant breach doesn't necessarily resolve our concerns about the sustainability of the capital structure. We often need a demonstrated track record of some level of business or earnings profit stability before an upgrade. We monitor how a business evolves, but most important whether that translates into meaningful cash flow and a fundamental improvement in its ability to service debt. The upgraded group indicates this collectively with notably stronger credit metrics than both the 'CCC' group and the 'B-' group. Most notably, FOCF of the upgraded entities is positive, surpassing at least half of the companies in the 'B-' group. It reflects the need for a track record of business improvement, given that many 'CCC' category issuers often have vulnerable business profiles or face high execution risk.

Chart 3

Speculative-Grade Borrowers May Be Returning To Cash Preservation, But 2022 Was Loaded With Shareholder Rewards And Heavy Working Capital Investment

A strong 2021 bolstered by pent-up demand has left companies with more cash on hand (including cash equivalents such as short-term investments) by the end of 2021, based on more than 900 speculative-grade corporate borrowers. But growth reversed in 2022, with capital deployed and profit growth decelerating. At $129 million, the year-end 2022 cash balance was a 23% decline from $167 million at year-end 2021.

Chart 4 shows how capital was allocated in 2022 versus the prior year. We urge readers to focus on the rate of change rather than the values. In 2022, there was a pivotal shift as sustained high inflation and the rising cost of capital threatened the top-line revenue expansion (the top line improved overall year over year--most were able to sell, though not all could pass costs) and/or interest coverage and FOCF, prompting companies to preserve cash as the year played out. Still, there were more shareholder reward activities in 2022 as dividends and share repurchases surpassed the prior year. Median dividends were $2.8 million and share repurchases $6.2 million, though bustling activities among sectors such as oil and gas and chemicals featured significantly higher numbers. Median increases in dividends and share repurchases (calculated by taking the median of changes on a company-by-company basis) are dominated by companies rated 'B+' and higher, with medians for lower rated companies declining.

More investments were poured into working capital in the last year, resulting in cash outflows. Highly leveraged 'B-' companies needed additional working capital to sustain operations or continual investment to grow into their balance sheets. Masked by the median figures, however, are some large cash inflows, most notably in the retail and restaurants and real estate (including homebuilders and REITs) sectors. Managing working capital needs has proven more difficult than expected in the face of inflation and supply chain challenges. In some cases, losses were made owing to the large inventory overhang. We expect inventory reduction in retail and restaurants this year, turning working capital into a modest source of cash.

Similarly, uncertainty about future demand might have deterred companies from making large spending decisions in the second half. But in the full year 2022, more capex has been invested in growing businesses. The median increase in spending (again calculated taking the median of changes on a company-by-company basis) was 27% on an aggregate basis, with increases relatively balanced across rating categories of 'B-' and higher. On a sector basis, higher spending was most significant for oil and gas (62% year-over-year growth) and forest products/building materials companies (43%). For 'B-' companies, capex increased on a median basis, but cash uses for all other categories (dividends, share repurchases, working capital, and acquisitions) were lower.

As we expected, leveraged buyouts, mergers, and acquisitions dropped precipitously from the 2021 high, but a steady stream of small tack-on acquisitions remains that we expect to continue, albeit at a fraction of its peak. Median acquisitions decreased 50% in 2022. Heavy reliance on access to the capital market is one reason acquisition spending was on a different trajectory from other accounts of capital deployment.

Chart 4

First-Lien Recovery Prospects Started 2023 At The Lower End Of The Post-2017 Range

Chart 5 illustrates quarterly trends of our recovery expectations for first-lien new issues, measured by the average recovery point estimates. Buyers of leveraged loans and secured notes are behaving more conservatively, and there was little new-issue activity in the second half of 2022. Risk aversion culminated in the last quarter, when the average recovery reached the highest level of 66% over two years. Some risk appetite returned in the first two months of 2023 before it was cut short by the collapse of Silicon Valley Bank. Still, new issues doubled in the first quarter, and average recovery estimates retreated to 63%, in line with the quarterly average since June 2020. The past decade marked a period of declining first-lien recoveries from the historical average. Based on data collected from North American companies that exited Chapter 11 bankruptcy, actual recovery of first-lien debt averaged 78% in 2008-2019 and 68% from 2020 to the second quarter of 2021.

Breaking down trends by recovery rating category, the share of '3' recovery ratings (which implies 50%-70% recovery in the event of payment default) remains the largest category, accounting for two-thirds of total new issuance in the first quarter (chart 6) and is led by issuance from the media, entertainment, and leisure sector. Caesars Entertainment Inc. placed a $2.5 billion term loan B and $2 billion of 7% seven-year senior secured notes in January as part of a refinancing effort to push out 2024-2025 maturities. Higher recovery assessment of '1' (recovery expectations of 90%-100%) and '2' (70%-90%) represented a quarter of total new issuance, including a $1.75 billion, seven-year term loan B for Uber Technologies Inc.

First-lien recovery is mathematically affected by leverage and the size of the junior cushion, and this would be evident if looking at a specific debt instrument. However, a fairly large range can depend on other factors coming into play, such as the timing of bankruptcy and emergence, complexity of debt structure, the presence of prenegotiated restructuring plans, or protective provisions in the credit agreement. These factors can influence the magnitude of the ultimate recovery.

Chart 5

Chart 6

Appendix: EBITDA Growth, Interest Coverage, Leverage, And FOCF Trends

Below, we summarize key credit trends, including interest coverage, FOCF to debt, profit growth, and leverage. We review how these metrics have transitioned over time through rolling-12-month windows (last-12-months or LTM) that ended on each quarter-end. We compare these LTM metrics' quarter-over-quarter change to track the transition of EBITDA growth. The sample covers 755 public and private companies that we rate in the U.S. and Canada. More details on how we built the sample are in Data Used In This Report section below. Due to the time lag in filing annual reports, the sample is smaller than usual and less robust. The companies in this data set skew towards companies that file public financial statements which tend to be larger and more highly rated. Similarly, concentrations of larger and more highly rated companies will skew median statistics in the breakdowns by sector. As a result, we refrain from drawing conclusions from the data at this time, but still thought the information might be of interest to readers.

Table 1

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Table 5

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Rated Research

• New Study Finds U.S. Speculative-Grade Issuers Most Vulnerable To Higher-For-Longer Interest Rate Environment, March 27, 2023
• U.S. Leveraged Finance Q4 2022 Update: Inflation Pressures Hit Margins, Rate Rises To Hit Cash Flow, Feb. 7, 2023
• Recovering From COVID-19: Why The Timing Of Bankruptcy And Emergence Matters For Debt Recovery, Feb. 7, 2022