S&P Global Ratings is seeing an uptick in defaults for North American corporate entities in 2023 amid higher-for-longer policy rates from the Federal Reserve, sticky inflation, uneven economic performance, and more cautious capital markets. We expect this to pressure cash flows and profitability, as well as hurt valuations. While a majority of the loan issuances in 2023 were through refinances, not all companies found the appropriate spread windows to refinance their maturity wall. If these difficult credit conditions, higher rates, and reduced valuations persist, lower debt recoveries are likely for entities that enter or emerge from bankruptcy over the next few years.

Furthermore, depressed valuations and secondary pricing have led to a vast number of borrowers entering out-of-court restructurings over the past 18 months via liability management transactions. Often, these restructurings do not permanently fix unsustainable debt structures and, as such, may further impair future recovery rates absent substantial improvements to operations or credit market conditions. These transactions provide borrowers with new capital and temporary relief from near-term liquidity pressures, but, more often than not, to the detriment of a group of existing lenders particularly in terms of collateral position and rights of claim.

The current high interest rate environment is in stark contrast to the low rates that have persisted since the global financial crisis of 2007-2009, which allowed companies and markets to be comfortable with high debt leverage. The ample availability of capital made it relatively easier for firms to access markets before the pandemic and through early 2022. What the market considered sustainable debt structures and leverage then are now strained following the sharp increase in interest costs starting early 2022 while inflation continued its incline.

In the first nine months of 2023, about 30 companies rated by S&P Global Ratings have filed for bankruptcy, including high-profile names such as Bed Bath & Beyond Inc., Party City Holdings Inc., Serta Simmons Bedding LLC, Yellow Corp., KNB Holdings Corp., and Diamond Sports Group LLC. Some of these 2023 bankruptcy cases have resulted in liquidations and partial wind downs of its businesses, leading to worst-case scenarios for some creditors. This may be a precursor to a period of depressed recoveries overall, especially given widespread expectations that the economic environment may worsen before inflation and rate hikes reverse meaningfully.

For information on the dataset and our process, see the appendix.

Average Recoveries By Debt Class

Chart 1

First-lien debt recoveries

In the most recent five-year period of 2018-2022, average first-lien recoveries totaled 72%. This was a decline from the previous 10 years, mainly due to below average first-lien recoveries of 67% in 2018 and 66% in 2020. The low recoveries for companies that emerged in 2018 primarily reflect poor first-lien recoveries for retailers under strong secular pressure with large priority working capital claims, while the 2020 recoveries reflect the effect of emerging during the economic weakness and uncertainty during the COVID-19 pandemic. Together, these years included 61 of the 105 companies that had first-lien debt in this period, with the bulk of the data points in 2020 (42 firms).

On the other hand, emergences in 2021 and 2022 saw average first-lien recoveries spike to 78% and 100%, respectively. First-lien lenders received full recoveries for 18 out of 27 companies as the economy normalized, oil prices reverted to its historical $50-$80 dollars per barrel, and retail consumption returned. Companies with full first-lien recoveries included rental car company Hertz Global Holdings Inc. (BB-/Stable/--), telecommunications group Frontier Communications Corp., as well as retail mall REITs Washington Prime Group Inc. and CBL & Associates Properties Inc. (B/Negative/--).

Entities that bucked the trend of high recoveries in 2021 and 2022 were Fieldwood Energy LLC, J.C. Penney Corp. Inc., Ascena Retail Group Inc., and media and publishing company LSC Communications Inc. While Fieldwood averaged a 51% recovery on $1.1 billion of first-lien debt through a credit bid, the others exited bankruptcy through 363 asset sales, with J.C. Penney garnering 25% first-lien recovery, Ascena with 19%, and LSC with 15%. Still, there was a 100% recovery for the asset-based loans (ABL) in each case.

For the nine months ended Sept. 30, 2023, the average first-lien recovery was 69%, consisting of four companies. This includes retailer Party City (which we included as we were able to obtain the recovery data earlier although its effective emergence date was October 12, 2023), which weighed down first-lien recovery rates because its $900 million in secured notes received a negligible recovery of less than 5%. Several recent bankruptcy cases are currently being resolved and liquidating assets. As such, their recoveries are not available or included at this time. However, they will likely drag down recovery rates further when the data becomes available.

Unsecured debt recoveries

Average unsecured recoveries have been been close to 30% in each of our five-year periods, including the latest. However, there is quite a bit of variation in annual average unsecured recoveries in the most recent period. For example, amid the COVID-19 pandemic in 2020, average unsecured recoveries dipped to 19%, then rebounded to 41% in 2021 alongside the economy. However, through the first nine months of 2023, unsecured recoveries dipped sharply to about 5% on average, which has pulled the the overall 15.75-year average down slightly to 28%. A significant portion of this was Bed Bath & Beyond's $1 billion of unsecured notes, of which we expect a recovery of no more than 2.5% as the company exits bankruptcy via a wind down of its assets through various asset sales. The other unsecured recoveries included 13% on Altera Infrastructure L.P. and slightly less than 2% on Party City.

From 2018-2022, several large entities with significant unsecured debt stacks, such as Hertz, Washington Prime, West Coast utility Pacific Gas & Electric Co. (PG&E; BB-/Stable/NR), and infrastructure company Ferrellgas Partners L.P. (B/Stable/--), defaulted and emerged. They garnered high recoveries, benefitting from valuations boosted by favorable economic conditions and a relatively thin layer of secured debt. Frontier is also noteworthy company, given its large $10.9 billion unsecured stack that makes up 5.4% of aggregate unsecured debt in the dataset. It recovered 46% in 2021, which was well above the 28% average.

Focusing in on 2020-2022, we saw a much higher mix of unsecured debt as several larger companies filed for bankruptcy before or during the pandemic and emerged during this period. Prior to bankruptcy, these large companies had considerable access to the high-yield debt market.

For example, after the pandemic lockdown led to Hertz defaulting, it had $5.3 billion in prepetition debt, of which about 67% was unsecured bond issuances. PG&E also had a substantial secured and unsecured bond debt before it filed for bankruptcy in early 2019. Its bankruptcy filing was primarily due to the class action lawsuits and legal liability that arose from the West Coast wildfires. PG&E emerged in July 2020 and had over $21 billion in prepetition debt, consisting of 60% secured debt and 40% unsecured.

Chart 2

First-Lien Recoveries Show Stress In Recent Periods

The drop in first-lien recovery rates for the 125 companies that emerged over from 2018-2022 reflects a decline in companies that achieved over 90% recovery (chart 3). Recoveries over 90% shrank to 39% of the companies in comparison to 60% in the prior five-year period. Over the full 15 years, half of first-lien lenders achieved greater than 90% recovery.

In particular, trough periods in 2018, 2020, and year-to-date 2023 have pulled down first-lien lender recovery rates over the most recent 5.75-year period. These troughs include companies concentrated in sectors under stress even in otherwise healthy economic years. For example, in 2018, only 32% (6 out of 19 companies) of first-lien lenders garnered 90% or more in actual recoveries, with the next biggest grouping at 30%-50% realized by 26% of the lenders. These low recoveries were primarily driven by the secular decline in the brick-and-mortar retail sector as struggling retailers entered bankruptcy proceedings after the COVID-19 pandemic exacerbated an ongoing decline for the sector. In general, retail companies are inventory intensive; as such, their debt structure typically includes relatively large ABL facilities that represent much of the debt structure and absorbs most of the recovery value.

Amid the broad economic dislocation due to the pandemic, only 21% of first-lien lenders saw recoveries of 90% or greater in 2020, with another 29% of lenders realizing a 70%-90% recovery. While 2021 and 2022 emergences resulted in high recoveries as the economy expanded quickly and broadly, we anticipate seeing recoveries contract again in 2023 and 2024 as the economy softens and affects sectors unevenly.

Still, there are many entity-specific factors that influence ultimate recovery, including leverage, debt mix, and going-concern prospects. Also, as noted previously, the increase in aggressive out-of-court loan restructurings in recent years using priming loan exchange (or uptiering) strategies has the potential to complicate and skew recovery rates for first-lien debt by subordinating the priorities of a subset of first-lien lenders that did not participate in the restructuring. To mitigate this, we excluded from our dataset three companies (Murray Energy Corp., NPC International Inc., and Serta Simmons) that emerged from bankruptcy after September 2020. The NPC and Serta restructurings included new money super-priority loans that received full recoveries, with strong recoveries on the debt rolled up by participating creditors of 88% and 75%, respectively. The Murray Energy and Serta Simmons creditors subordinated in these transactions were essentially wiped out; for NPC, essentially all first-lien lenders participated.

Chart 3

Timing Of Emergence Influences Recoveries

A major factor in determining recovery levels is the credit and economic environment at the time of emergence from bankruptcy (see "Recovering From COVID-19: Why The Timing Of Bankruptcy And Emergence Matters For Debt Recovery", published Feb. 7, 2022). For example, we saw economic stress squeeze recoveries and cause uncertainty in 2020 at the height of the pandemic, only to rebound notably in 2021 and 2022 when economic growth returned. Additionally, there are peaks and troughs for debt recoveries that generally track to economic cycles or, more recently, the pandemic.

Over the long run, average actual first-lien recoveries were historically at 70%-80%, although it is lumpier on an annual basis because of the smaller sample set for each period. As such, the average actual recoveries for some years dropped to as low as 65%-70%. These low-average recovery years coincide with economic downturns, secular decline in sectors, or extraneous factors such as disruption from a pandemic, highlighting how the timing of an exit from bankruptcy influences debt recoveries, given the overall views on valuation and rates. The running average over our entire dataset is 78%, which is a percentage point below the pre-pandemic average.

Like first-lien recoveries, unsecured recoveries have demonstrated fluctuating recovery rates when looking at annual data. The key difference is that they primarily depend on residual value because senior secured or structurally senior creditors receive recovery values first with respect to its collateral and its respective rights of claim.

Chart 4

To smooth out the annual average recovery data, we also use a rolling 24-month average recovery for first-lien debt, weighted average, and unsecured debt (chart 5). Using this lens, we see troughs below 50% in weighted average recoveries from 2012-2013 and for a longer stretch in 2016-2017 (during the oil and gas downturn). For first-lien debt, we see an extended period below 80% between 2011-2013 (while coming out of the global financial crisis) and for a much longer stretch between 2018-2022 (amid secular decline in retail and oil and gas bankruptcies from 2018-2019 and during the pandemic before spiking up in 2022. We now see an indication that it is heading downwards so far in 2023.

Chart 5

Recent Weighted Average Recoveries Skew Higher

The weighted average recovery is the recovery rate for a company's total debt structure. Within each five-year period, it has averaged 49%-55%, with an overall average of 52% across the 15 years. The 15-year distribution reflects a normal bell curve (chart 6).

Chart 6

However, the weighted average recovery for the most recent five-year period of 2018-2022 was 55%, which is six percentage points over the prior period. This reflects the higher level of very high recoveries not only for first-lien debt, but also for junior-level debt, as well as the sharp economic rebound in 2021 and 2022 that boosted valuations and recovery rates.

Lenders that benefitted during this period include Ferrellgas Partners, Hertz, and Mallinckrodt, which had large unsecured debt stacks that realized above average recovery rates, thus shifting the distribution toward the 60%-80% range. Furthermore, we see a 70% average weighted average in 2022, which reflects these companies with high unsecured debt stacks (chart 4).

Long-Term Recoveries Potentially Constrained

We saw above average first-lien recoveries in 2021 and 2022 as North America recovered from the height of the pandemic, with valuations benefiting from strong growth, low rates, and robust market liquidity. However, outside of these two years, the overall long-term trend for first-lien recoveries is down, as evidenced by just 38% percent of companies with first-lien debt achieving greater than 90% recoveries over the past five years while an increasing number of companies (39%) is achieving 50%-90% first-lien recoveries. This trend generally correlates to our recovery rating average recovery estimates of low-60% (chart 7).

Further, with the current high interest rate, inflationary pressures on borrowers' cash flows, and the volatility of rates, we anticipate valuations to follow along the expected recovery trends. As debt capacity is potentially limited and equity investors demand higher returns to offset their own cost of capital, recoveries could be constrained for defaulted companies, unlike the high recoveries achieved in 2021 and 2022.

Chart 7

Appendix

Table 1

Our empirical recovery dataset covers 15 years and consists of 370 North American companies, aggregating to almost $0.7 trillion dollars in total debt. This data set covers entities rated by S&P Global Ratings that defaulted, entered bankruptcy administration, and emerged between 2008 and the end of third-quarter 2023. We broke the first decade into two five-year periods; the final five-year timeframe, which includes the COVID-19 pandemic, we further split into pre-lockdown and post-lockdown segments, with one final segment representing the nine months ended Sept. 30, 2023.

Our dataset covers rated companies that filed for bankruptcy in the U.S. or Canada where we have sufficient information to obtain actual recovery rates from the bankruptcy documents. Debt amounts reflect the amounts outstanding at default. We exclude recoveries from distressed exchange transactions and companies that we could not obtain actual recovery data from--in particular, bankruptcy dockets.

In addition, our recent data excludes three companies that completed priming loan exchanges in recent years. These transactions can skew and complicate first-lien recovery rates because the newly issued first-lien debt (and typically some of the existing debt held by participating lenders) is structured to have a higher priority claim than the first-lien debt held by non-participating lenders. The three companies that we excluded, Murray Energy, NPC International, and Serta Simmons Bedding LLC, emerged from bankruptcy between September 2020 and Sept. 30, 2023.