Higher-for-longer interest rates are proving to be particularly troublesome for smaller, lower-rated firms. Median EBITDA growth overall slipped again on a trailing-12-months basis at the end of the first quarter, consistent with the trend since mid-2021. Even with most companies exhibiting slower profit growth, some sectors such as hotels and lodging still managed to pull off impressive year-on-year growth in S&P Global Ratings' dive into performance trends for the first quarter of 2023--including top-line sales, EBITDA, and debt.

Energy and commodity companies face a tougher comparison as 2022 was bolstered by a price surge following Russia's invasion of Ukraine. In addition, we continue to track the evolution of interest coverage and free operating cash flow (FOCF) to debt of speculative-grade borrowers. Our data suggests brewing credit strain among smaller and lower-rated borrowers, characterized by notably weak credit measures that set them apart from larger counterparts. Their ability to support increasing interest payments and other cash spending needs is strained. On a positive note, we started to see progress in speculative-grade companies addressing working capital that has improved free cash flow, most evident among the borrowers we rate 'BB-' and 'B+'.

Lastly, in this report we analyze the impact on first-lien recovery rates from the increase in first-lien-heavy and first-lien-only debt structures. First-lien-only structures account for 38% of the 1,263 obligors with outstanding first-lien debt. On average, their estimated recovery falls significantly behind that of those with a cushion of 30% or more by 31 percentage points (61% versus 92%) and 42 percentage points (58% versus 100%) on a median basis. We also look at the latest trends in recovery ratings on newly issued first-lien debt.

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

First-Quarter Trends: Sales, Profit, And Gross Debt

To glean insights on the latest performance, we compare revenue, EBITDA (as reported in financial statements), and gross debt in the first quarter of 2023 and the 12 months ended on March 31, 2023, with the respective comparable period one year prior (tables 1-3). Our data is from about 1,100 speculative-grade rated companies in the U.S. and Canada, both public and private entities. We break this down to reveal nuances among subsectors, entity ratings, and entity sizes.

The data shows, by median measures, earning pressures were evident as the momentum in revenue growth decelerated. This corresponds to our view of mildly negative momentum in earnings forecasts, underpinning recent negative rating actions.

That said, companies still pulled off a substantial gain relative to the same period one year ago. Over half reported higher EBITDA in the three months ended March 31 versus a year earlier, and more so in the broader horizon of 12 months to March 31 (10.2% year-over-year increase). This is helped in no small part by the enduring strength of consumer spending and low unemployment. Our baseline U.S. forecast no longer includes a recession, but a longer period of below-potential growth. In addition, freight and input price inflation (led by supply chain disruptions) appear to be in remission, although the market still bears those scars.

Thus far, EBITDA growth is largely aligned with revenue growth. The few subsectors that failed to translate solid revenue gains into a stronger EBITDA include health care equipment, REITs, and textile and apparel, where inflation and wage costs have wiped out gains in the top line.

Meanwhile, gross debt is essentially flat over the same period judging by both group median and aggregate. The flatlining of the debt burden since 2022 is less driven by external fundraising than incremental interest costs. This is because leveraged buyouts, mergers, and acquisitions were largely absent from the capital market last year. The forecast remains anemic for the rest of the year as credit conditions are challenging.

Performance Trends By Sector

Table 1

• Classically, subsectors the most sensitive to interest rates feel the most pain. EBITDA slumped 53% with homebuilders and real estate developers, for one, on a quarter-over-quarter basis and 28% on a year-over-year basis in the first quarter, and nearly half with a decline larger than 30%. The same headwinds--brought on by much higher mortgage rates, persistent cost pressures, and tightening of credit standards--also weighed on the building materials and products subsector with slowing demand for home repairs and construction. Despite largely expected declines in revenue and margins, the recent performance of homebuilders has held up better than we anticipated due to limited inventory and resilient buyer demand. Reduced working capital usage as the homebuilders pull back on land spending could also become a source of cash to support their financial flexibility.
• As leisure and business travel return to pre-pandemic levels, most media, entertainment, and leisure companies have notably outperformed last year (admittedly from a low base) at both a top-line and profit level. The improvement is broad-based, led by hotels and lodging, and closely followed by leisure operators. Both enjoyed a significant jump in the past 12 months. We observed a similar trend entailing demand recovery in air transport including airlines. In contrast, TV and radio companies had top-line pressures due to secular pressures and a pullback on advertising budgets. We expect national advertising will remain weak in 2023.
• Many semiconductor firms are stuck in a period of destocking or a return to normal buying patterns. This has hurt demand and contributed to a rapid EBITDA downturn in the first quarter of 2023, a 19% year-over-year drop.
• In automotive, we expect pricing pressure and lower demand for aftermarket auto parts amid worsening macroeconomic conditions. Consumers may delay replacement of certain auto parts or buy lower-cost products; both would weaken the product mix of auto parts producers and suppliers. Nonetheless, eventually the recovery in vehicle miles traveled since the height of the COVID-19 pandemic and the steady aging of car fleets will likely support continued growth in auto parts.

Performance Trends By Issuer Rating

Table 2

• Weakness in quarterly EBITDA performance was predominantly in the higher speculative-grade categories.
• EBITDA trends for entities in the lower 'B' rating category outperformed those of 'BB' rated companies in the first quarter, a trend that persists even after we remove rating movements from the sample. Specifically, among all ratings, 'B-' rated companies improved most significantly (7.4% year over year and 6.8% quarter over quarter).
• We believe there are several reasons for this. First, the biggest movers (defined by percentage change) are confined to a group of small entities with often volatile performance as they expand from a small base. Out of the companies we rate 'B-', 12 among the 20 largest year-over-year gains reported negative EBITDA in the first quarter of 2022, increasing to positive, and another seven had EBITDA of $10 million or less. While the improvement is noteworthy in percentage terms, this still indicates negligible profitability in dollar amounts. Second, the record-breaking volume in mergers and acquisitions in 2021-2022 is behind the disparity. Companies are reaping the benefits of these earlier acquisitions, gaining size, achieving synergies, and realizing cost savings. This has a disproportionately large positive effect on the sponsor-backed 'B' rated entities that were highly active in 2021. Supplementing organic growth with tuck-in acquisitions is a strategy we often see among sponsor-backed entities. Lastly, the disruption caused by the pandemic and subsequent cost inflation severely affected financially weaker companies. Due to smaller scale and more limited pricing power, setbacks in raising prices and/or longer lags in passing on cost increases than their higher-rated peers were frequent. Comparing the two 12-month periods makes the latter an easier comparison with the earlier one, which was still distorted by the pandemic-induced recession.
• Our entity ratings are as of June 20, 2023. Companies rated 'BB+' and 'BB' in the table include three fallen angels: Kohl's Corp. (department stores), SL Green Realty Corp. (REIT), and Office Properties Income Trust (REIT), which weigh down the group-level performance. Department stores exemplify the struggle retailers face in striking a balance between inventory management and sales promotion. The need for heavy markdowns to clear inventory puts downward pressure on operating margins. The six department stores we track reported a year-over-year median EBITDA drop of 33% in the first quarter 2023. Of those, Kohl's incurred an EBITDA loss, a huge turnaround from its $657 million gain in the first quarter of 2022. Soft sales trends are behind the deterioration due to weakening consumer demand for discretionary products, inventory realignment, and challenging year-over-year comparisons from the first half of 2022, which was bolstered by robust consumer spending.

Performance Trends By Company Size

Table 3

• Heightened volatility and wide dispersion among companies are noted in the smallest-size bucket, companies with EBITDA of $50 million or less. Performance in the first quarter of 2023 interestingly shows that although median 5% aggregate year-over-year growth is better than most size buckets, about one-third of these companies suffered year-over-year decline that exceeded 30% and about a quarter exceeded 50%. This highlights a great deal of company-specific differentiation within the cohort.
• In contrast, the performance of the largest-size cohort (EBITDA of more than $1 billion) trended downward in the first quarter from the prior and year-ago periods. An examination of the industry mix provides a clue: a notably high concentration of energy and commodity companies. Specifically, oil and gas exploration and production, the largest subsector within the bucket, made up 21%, followed by metals and mining at 10%. They represent just 4% each in the total population. Commodity prices receding from pandemic highs is behind some of the slowdown over the past year. Prices for oil and natural gas were much higher one year ago following Russia's invasion of Ukraine.

Interest Coverage, FOCF, and Leverage Trends

We reviewed how metrics for interest coverage, FOCF to debt, leverage, and EBITDA growth have transitioned over time through rolling-12-months windows at each quarter end. This most recent sample covers 940 public and private companies that we rate in the U.S. and Canada. (More details on how we built the sample are in the "Data Used In This Report" section below.)

The erosion in EBITDA interest coverage has been gradual, and it has only recently become evident in trailing-12-months metrics, as the burden from past interest rate hikes is more fully reflected in cash flows at the same time that EBITDA growth has slowed. Median 12-month EBITDA interest coverage dipped to 3.3x in the first quarter of 2023, down 0.3x from year-end 2022 (Appendix tables 7-9). We believe higher-for-longer interest rates will likely expose weaker borrowers later in the year. Smaller issuers face a genuine concern as their particularly weak credit measures distinctly differentiate them from their larger counterparts. For the 12 months ending on March 31, issuers in the smallest-size bucket show incomplete median interest coverage of 0.6x. Additionally, median leverage is as high as 20x, underscoring their increased vulnerability to payment defaults, especially amid an unfavorable economic and credit market conditions.

As another indication of potential strain, median interest coverage for 'B-' rated entities stands at 1.5x after two consecutive quarterly declines. This means more than half of this cohort is only a half turn or less away from the critical threshold of 1x, which is generally associated with distress. In fact, 21% of 'B-' rated companies are already below 1x coverage within the sample. This places additional constraints on their operating flexibility and makes them vulnerable to an eventual default.

On the positive side, FOCF-to-debt metrics are at their best since 2021 (Appendix tables 10-12). The first quarter of 2023 brought a substantial improvement of 0.8 percentage points from year-end 2022. We attribute this to improved working capital flow due to slower operating conditions and inventory reductions. These factors enhanced free cash generation. For example, consumer products and restaurants/retailing issuers benefit from working capital inflow as they work down bloated inventory. We observed similar improvement elsewhere in the capital goods/machine and equipment sector, with FOCF to debt rising to 1.5% from 0.7%.

Recovery Cushion Study

We look at the effect on first-lien recoveries resulting from the increase in first-lien-only and first-lien-heavy debt structures, as layers of more junior second-lien and unsecured debt become more uncommon and thinner. Our definition of available cushion is the amount of debt that is junior to first-lien debt as a percentage of total debt. Our findings further confirm the high correlation between junior debt cushion and anticipated first-lien recoveries. As one would expect, the latter improves with higher cushions. First-lien loans that have a cushion of 30% or more hold a significant lead over those with a negligible or nonexistent cushion, as observed in first-lien-only structures.

In our review of 1,263 speculative-grade obligors with first-lien debt outstanding, 511 or 40% have less than 10% of available cushion beneath them (chart 1). Of that, 93% have zero cushion, meaning the entire debt stack is first-lien secured (including bank loans and senior secured bonds) with the same payment priority. In other words, about 38% of first-lien creditors in our sample, though often enough the most senior in the pecking order, could take the first dollar of loss in an insolvency.

Chart 1

Average recovery estimates for this nonexistent-to-diminutive cushion group (0%-10%) is 61%, notably below our historically observed average of 68%--based on North American companies that exited Chapter 11 bankruptcy between 2020 and the second quarter of 2021. It's 78% for those that exited between 2008 and 2019. Furthermore, within the group, the forecast for recovery is weaker for first-lien debt that is subordinate to a priority claim, such as an asset-backed loan (ABL) facility. They trail those without a priority claim by 2.7% (58.8% to 61.5%). On average, the gap between the two is about 2.5% for all cushion buckets except the above-70% bucket.

ABL facilities, accounts receivable factoring, and floor plan financing are common forms of priority debt, especially among retail, automotive parts producers and suppliers, and building materials and products borrowers, given their asset-rich working capital. They allow companies to build more borrowing flexibility during a seasonal (or a lingering) downturn. In return, lenders are offered a priority claim on obligors' quality assets (i.e., accounts receivable and/or inventories), lowering recovery prospects for first-lien term lenders.

Ownership of hard assets such as land, buildings, equipment, or mineral reserves can also improve recovery prospects, especially for secured lenders with liens on them. This factor, combined with higher debt cushion, contributes to our expectation that first-lien claims in the oil and gas sector will attain a higher recovery, surpassing 90%. This is about 1.4x greater than the all-sector average of 70%, and significantly above the average of 63% for health care services.

We have also noticed that recovery estimates vary across a fairly wide range. This is because, in addition to junior debt subordination, first-lien recovery prospects are influenced by various factors, including an obligor's overall leverage, the quality of the collateral package and business in a default scenario, timing of bankruptcy and emergence, and the presence of protective provisions in the credit agreement.

First-Lien New Issue Recovery Prospects

New issuance has again been light on the leveraged loan primary front. So far this year, we have assigned recovery ratings to just 285 new first-lien instruments involving 184 companies, despite an increased pace of secured bond issuance. This is a significant drop from 721 first-lien instruments in the first half of 2021. Chart 2 illustrates the quarterly trends of our recovery expectations for first-lien new issues, measured by the average recovery point estimates. During the second quarter of 2023, investors sought out high-quality debt, as the market generally shied away from riskier assets. As a result, the average recovery estimate for new issues inched up to 66% from 63% in the previous quarter. The average estimate has hovered near 65% over the past few quarters.

Meanwhile, the share of issues with '3' recovery ratings (which implies 50%-70% recovery in the event of payment default) dipped to 56%, the lowest since the third quarter of 2020 (chart 3). Much of that was taken by higher recovery assessments of '1' (90%-100%) and '2' (70%-90%), which combined accounted for a 36% share versus 25% in the first quarter.

Chart 2

Chart 3

Appendix

Table 4

Table 5

Table 6

Table 7

Table 8

Table 9

Table 10

Table 11

Table 12

Table 13

Table 14

Table 15

Rated Research

• Real Estate Monitor: Tightening Access To Capital Heightens Refinancing Risk, June 5, 2023
• U.S. Leveraged Finance Q1 2023 Update: Ch-Ch-Ch-Changes -- Material Shifts In Key Credit Stats Drove Downgrades To 'B-' And 'CCC', And Upgrades To 'B-', May 4, 2023
• Recovering From COVID-19: Why The Timing Of Bankruptcy And Emergence Matters For Debt Recovery, Feb. 7, 2022