Loan prices in the Morningstar LSTA US Leveraged Loan Index have climbed 232 basis points in 2023, with a return on pace for one of the strongest years since the Great Recession. Just over 8% of performing loans were priced at par or higher and less than 5% were below 80 at the end of October. This is a sign of strong demand and a landscape of investors prepared to pay more for the right assets.

In our view, the sustained rally, in part fueled by the low supply of primary issuances, runs the risk of misplaced optimism. It is likely out of sync with the credit fundamentals of some of these issuers.

One critical factor is the potential challenges for lower-rated borrowers to refinance near-term debt maturities. To evaluate this, we recharacterized the maturity wall to reflect the potential impact of springing maturities. This involved pulling maturities forward to the first year when a quarter or more of a company's total outstanding debt comes due. The exercise (which uses our data from a sample of about 1,300 speculative-grade companies) suggests that refinancing needs could be much higher than otherwise indicated, with 2024 and 2025 maturities representing 18% of the outstanding debt currently held at 'B-' rated borrowers.

Later in this report, we continue to track the credit quality of speculative-grade borrowers in North America through the lens of four key credit metrics: median EBITDA interest coverage, free operating cash flow (FOCF) to debt, gross leverage, and EBITDA growth. On a 12-months basis, EBITDA growth has declined since its peak in mid-2021. This quarter, we dive deeper into the credit characteristics of loan-only and bond-only borrowers. The rapid rise in interest rates has brought a wave of disruptions to the loan-only segment, in which the median EBITDA interest coverage ratio dipped to 1.8x in the 12 months through the second quarter of 2023 from 2.1x at the start of the year. It's also 3.8x below the median of bond-only issuers, which was 5.6x in the same period. We expect this partly given the former's leveraged balance sheets and rising rates. It's also a sign of slowing economic momentum.

Lastly, we 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.

Maturity Wall Has Transformed

The debt maturity profile is a critical component of our assessment of a company's capital structure, and it could make liquidity and refinancing problematic if not carefully managed. This year, many speculative-grade borrowers have made progress pushing out their debt-maturity profiles beyond the next two years. Institutional loans maturing in 2024 totaled $16 billion as of Oct. 27, 2023, down 79% from the $75 billion at the beginning of the year, according to PitchBook LCD (chart 1). The maturity wall has shifted noticeably across the rating spectrum.

Chart 1

However, we believe focusing solely on the size of near-term maturities understates the potential ripple effects these front-loaded payment obligations might have on the rest of a borrower's debt structure, especially considering the frequent presence of springing maturity clauses. Debt often is immediately due should the issuer fail to address a maturity via refinance, extension, or redemption of another instrument (often one of junior seniority) within a specified period (say, 91 days before maturity). Furthermore, senior lenders are often hesitant to extend loans beyond the maturity dates of junior debt. To assess the downside impact from potential springing maturities, we transformed the maturity wall by showing the total outstanding debt of the borrower--rather than just the portion due within a single year--starting from the first year that 25% or more of a borrower's total debt comes due.

For example, we accelerated to 2024 the entire outstanding debt balance including a term loan maturing in 2027 if that's when a meaningful size of unsecured notes is due. We believe this approach creates an "early warning" system even when a company's maturity schedule, at first glance, might seem well spread out rather than compressed at the front end. Naturally, not all payment obligations are tied to the earliest maturity date. The inability to refinance or extend a meaningful portion of the debt ahead of the earliest maturity could trigger a chain reaction.

An additional $77 billion in debt held by 74 entities may come due in 2024, constituting 3% of the total outstanding debt in our sample of about 1,300 speculative-grade North American companies (chart 2). Following this is an additional $313 billion involving 200 entities in 2025 (representing 12% of the total debt in dollars and 16% of the total entity count) and over $550 billion (21% of total debt) in 2026. While the immediate maturity outlook still appears manageable for the most part even in this more adverse scenario, lower-rated speculative-grade borrowers as a whole still have a way to go, particularly when their capacity to refinance or extend remains sensitive and fragile.

The market has been optimistic despite rising uncertainty. Refinancing windows will revolve around a complex interplay of the underlying economy (consumer demand and employment), the U.S. Federal Reserve's tightening cycle, and fiscal policy. On top of this, geopolitical events and other disruptions could move the market into new bouts of volatility, which could abruptly constrain a borrower's ability to refinance.

Chart 2a

Chart 2b

As expected, better performing and higher-rated firms have found the most ease with extending maturities. They were a better cohort with relatively low leverage and better debt service capacity. However, the pressure is weighing on the lower tiers. Data by entity rating (chart 3) shows 18% of the outstanding debt held at 'B-' rated borrowers will come due within the next two years. An additional 16% will need refinancing or extensions by 2026. Ongoing cash flow deficits and tightening lending standards coinciding with market volatilities have made it difficult for this segment to unlock new sources of capital. For them, the competition to secure financing is alive and well. Failure to roll over debt before it turns current or making a distressed exchange would likely lead us to downgrade a company into the 'CCC' category or lower.

Following our recharacterized maturity wall, the share of debt maturing in 2024-2025 spiked to 28% among 'CCC+' rated borrowers and exceeded 50% for both 'CCC' and 'CCC-' rated borrowers. This aligns with our assessment that 'CCC' rated entities are at high risk of nonpayment and face at least a 1-in-2 chance of default. In the absence of a definite plan to extend maturities, such a company may seek a capital injection from its owner or the sale of noncore assets to augment refinancing prospects. Some issuers may even consider more aggressive out-of-court restructurings such as asset or collateral drop-downs, up-tier priming loan exchanges, or other unconventional (and often controversial) tactics to alleviate liquidity constraints.

Chart 3

The urge for refinancing is most pronounced in the oil and gas and chemicals sectors (for which performance is contrasting). Each has 7% of debt maturing as early as next year, closely followed by technology at 5%. Thus, it's worth noting that our debt tally includes accounts receivable facilities or funding programs that rely on issuing short-dated asset-backed securities even though we usually expect these to be replaced or renewed.

Chart 4

Interest Coverage, FOCF, And Leverage Trends

Below, we summarize key credit trends in interest coverage, FOCF to debt, leverage, EBITDA growth, and capital expenditure (capex). We reviewed how these metrics have transitioned over time through rolling-12-months windows that ended on each quarter-end through June 30, 2023. Our data set comprises 908 public and private companies in the U.S. and Canada. More details on how we built the sample set are in the "Data Used In This Report" section at the end of this report.

The effect of higher benchmark rates continues to flow through trailing-12-months interest coverage, with the portfolio's median falling by 0.4x in the first half of 2023 to just below 3x. Credit measures for smaller issuers, especially those with EBITDA under $50 million, and those rated in the 'CCC' category continue to deteriorate and signal distress, with 70% of smaller issuers and 53% of those rated in the 'CCC' category having less than 1x coverage. These companies will face liquidity shortfalls as their borrowing capacity or debt maturity headroom narrows. Issuers that we rate 'B-' are also likely to be under ongoing pressure, considering their median interest coverage fell to 1.4x as of June 30, 2023 (from 1.6x in 2022), leaving them with modest financial flexibility. Although median FOCF for the 'B-' rated cohort turned marginally positive in the second quarter, issuers that fail to generate enough EBITDA to cover their interest expense (24%) or to generate free cash flow (50%) remained high.

However, FOCF to debt for the overall speculative-grade sample has consistently improved for the last three quarters, with the last-12-months median (ending in June 2023) up 1.6 percentage points from year-end 2022. We attribute this to a recent slowdown in capital spending across rating categories and better working capital inflow on accounts receivable collections and inventory reductions, enhancing free cash generation. The most notable increases were in the auto/trucks, consumer products, restaurants/retailing, and real estate industries. Improving supply chains, pent-up demand, and production discipline have supported the auto industry. Issuers in consumer products and restaurants/retailing benefit from cautious capex and working capital inflow as inventory normalizes.

Real estate has benefited from homebuilders' market share gains as resale inventory remains low and buyers get accustomed to higher interest rates, given continued strength in the labor market. Also, companies in the nondiscretionary building materials segment have shown resilience.

Though capital discipline still supports free cash flow, a reversal in FOCF-to-debt trends have affected commodity-based industries including oil and gas, mining and minerals, and chemicals as prices normalize for the former two. In contrast, the chemicals industry faces demand weakness due to destocking across end markets.

Lastly, we compared the industry median of interest coverage against FOCF to debt for the 12 months ended June 30 (chart 5). The health care and aerospace industries both had interest coverage under 2x and significant working capital investments that dragged cash flow into negative territory. On the other hand, capex stood out as the dominant factor impairing free cash flow for telecommunications and transportation despite better median interest coverage.

Chart 5

Contrasting Loan-Only, Bond-Only, And Mixed Debt Structures

The loan-only debt structure has gained considerable traction, helping reduce the overall debt cost in the historical environment of low interest rates. We divide our credit metrics into loan-only, bond-only, and issuers with a mix of loans and bonds in the debt profile to study this development. To avoid being overly precise, a loan-only issuer by our definition can have other types of debt such as a cash flow or asset-based revolvers, equipment financing facility, mortgage note, or even an insignificant portion of high-yield notes (typically less than 10% of total debt). For instance, this could include a small stub of a high-yield note that's left to mature while most of the debt has been redeemed or a minor euro note issued by a Netherlands subsidiary of a U.S. parent. We present all financial metrics as a rolling-12-months median.

Collectively, the stronger credit standing of bond-only issuers is in the greater prevalence of 'BB' category ratings ('BB+'/'BB'/'BB-') within the group, making up 45% of the segment compared to only 10% in the loan-only group (chart 6a). Conversely, 'B' category ('B+'/'B'/'B-') rated issuers dominate the scene in loan only, accounting for 71% of the segment. Furthermore, the loan-only issuer rating outlook leans slightly negative than bond-only issuers (chart 6b).

Chart 6a

Chart 6b

The leverage comparison (chart 7) affirms the tendency for loan-only issuers to take on more debt rather than adopt a more conservative financial policy approach. As a result, all three of their credit metrics have consistently lagged behind those of the other two groups. Such disparities remain throughout our study window, mirroring the distinctions in our ratings. The gap between the median leverage of bond-only and loan-only issuers is 3.7x (6.4x vs. 2.7x) for the 12 months ended June 30.

Chart 7

EBITDA interest coverage has contracted across the board since mid-2022. However, despite loans being most exposed to rising rates, we don't observe a more rapid deterioration in interest coverage for loan-only structures relative to the bond-only group. That's because those issuers have collectively continued to churn out profit, which helped blunt the impact of higher interest expense. The latter suffered a noticeable profit decline. The outperformance in growth of the lower-rated and smaller-scale entities was discussed in detail in our second-quarter report, published Aug. 3, 2023. In summary, we attribute this to a delayed recovery, benefits stemming from many acquisitions in 2021, and overall volatile performance. While in some cases growth has surpassed year-earlier performance, it remains below pre-pandemic levels. Nevertheless, we do not view this outperformance as sustainable, especially if rates stay higher for longer. Lastly, bond-only issuers, having undertaken more refinancing, have incurred increased interest expense due to higher rates.

Still, pressure to meet interest payments is mounting among the loan-only group as tighter financial conditions filter through. This is manifested in the group's median interest coverage (chart 8), which fell to 1.8x as of June 30, 2023. We note that our trailing-12-months ratios do not reflect the totality of rate hikes. The full impact could be felt in the next two to three quarters. We expect ongoing ratings pressure, considering many loan-only issuers had limited cushion as rate hikes began. The situation could worsen if we enter a prolonged period of higher rates or slowing demand. By comparison, the median interest coverage of bond-only issuers is about three times that of loan-only issuers for the 12 months ended June 30.

Chart 8

FOCF-to-debt ratios have only recently started to rebound after declining steadily over the past two years (chart 9). The ongoing phase of destocking and softening demand has allowed companies to enhance FOCF. However, the gap between the loan-only segment and others has widened recently, suggesting that additional cost optimization or deleveraging measures are necessary for the former to restore historical ratios.

Chart 9

First-Lien New Issue Recovery Prospects

Though new issuances in the third quarter of 2023 have more than doubled to 179 from 72 in the third quarter of 2022, year-to-date issuance continues to be faint compared to 2021. Despite an increased pace of secured bond issuance, we have assigned recovery ratings to just 464 new first-lien instruments of 292 issuers. This is a significant drop from 1,040 in a comparable period of 2021. Quarterly trends of our recovery expectations for first-lien new issues are measured by the average recovery point estimates (chart 10). During the third quarter of 2023, investor risk appetite rose for 'B' category debt, with the share of issues 10% higher than the previous quarter. The average recovery estimate for new issues inched down to 63% in the third quarter from nearly 65% over the past few quarters.

Meanwhile, the issues with '3' recovery ratings (which implies 50%-70% recovery in the event of payment default) clawed back their lost share and stood at 65% (chart 11). However, most of the increase was taken from higher recovery assessments of '1' (90%-100%) and '2' (70%-90%), which combined accounted for a 29% share versus 36% in the second quarter.

Chart 10

Chart 11

Appendix

Table 1a

Table 1b

Table 1c

Table 2a

Table 2b

Table 2c

Table 3a

Table 3b

Table 3c

Table 4a

Table 4b

Table 4c

Table 5a

Table 5b

Table 5c

Related Research

• U.S. Leveraged Finance Q2 2023 Update: Disparities Emerge By Sector, Rating, Company Size, And Debt Cushion, Aug. 3, 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