Notwithstanding the noise and media reaction to every data point, the leveraged finance market continues to move with a positive tone. As we pass the midpoint of the year, we see a market that anticipates a record year of new broadly syndicated loans, collateralized loan obligation (BSL CLO) formations, and high loan issuance, albeit new loan and net BSL CLO creation are still flat to down given low merger and acquisition (M&A) and leverage-buyout volumes. Meanwhile, credit profiles of leveraged borrowers continue to evolve following the growth and resilience of the U.S. economy. To better gauge the current landscape, we track the credit trends of speculative-grade rated corporate entities in North America through key credit metrics: reported EBITDA interest coverage, free operating cash flow (FOCF) to debt, gross leverage, and other measures (see the Data Used In This Report section at the end of this report). Recent data indicate modest improvement: the erosion of interest coverage has slowed and FOCF to debt has made meaningful progress over the past few quarters. We also see an increasing emphasis on protecting profit margins in light of worries over economic growth and uncertainties surrounding political developments.

In our quarterly update, we dive into the credit characteristics of loan-only, bond-only, and mixed borrowers. Credit metrics across all three groups have followed similar trends, yet the metrics for loan-only borrowers have consistently lagged behind the other two groups. This reflects the disparity in credit ratings and underscores the loan-only issuers' tendency to require more debt leverage given high purchase price multiples amid a prolonged low interest rate environment. Looking ahead to the latter half of 2024 and beyond, our economists expect milder economic growth and the onset of rate cuts to start later this year under our base case forecast.

Lastly, new first-lien debt issued in the second quarter had an average estimated recovery of 61%, the same as the previous two quarters and the lowest level since 2017. Several factors account for the decline, including lenders' ongoing willingness to fund risky credits amid limited new issue supply. We also saw more opportunistic deal flow, including companies issuing new first-lien debt to take out second-lien debt or fund dividend recapitalizations. Also, increasing distressed debt exchanges have led to dispersed recoveries. For context, companies achieved an average first-lien recovery of 69% through Chapter 11 restructurings in the first three quarters of last year, which was a historic low.

Click here to access many of the charts and tables in an interactive format.

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

Over the past decade, we have observed a shift toward loan-heavy and loan-only debt structures, particularly those backed by private equity sponsors. This preferred approach has enabled companies to minimize overall debt costs despite high debt leverage given the historically low interest rate environment that persisted before early 2022. Our analysis in the past has shown that borrowers with loan-only structures have significantly higher leverage and lower estimated recovery than other structures. We revisit this topic to glean information and additional insights from additional quarters of data. Specifically, our assessment breaks down credit metrics by the issuer's debt profile--loan only, bond only, and mixed. Our data set comprises about 900 public and private companies in the U.S. and Canada. To keep the definition clean and broad-based, a loan-only issuer can have other types of debt such as a cash flow or asset-based revolving credit facility, an equipment financing facility, a mortgage note, or even an insignificant portion of high-yield notes (typically less than 10% of total debt)--for instance, a small stub of a high-yield note that's left to mature while the majority has already been redeemed or a minor euro note issued by a foreign subsidiary of a U.S. parent company. All financial metrics are presented as a 12-month rolling median.

Rating and industry mix are notably different

The rating mix clearly shows the stronger credit standing of bond-only issuers: while the bond-only cohort has a roughly even split across the 'BB' rating category ('BB+'/'BB'/'BB-') and 'B' rating category ('B+'/'B'/'B-'), loan-only is more heavily concentrated in the 'B' category, which makes up two-thirds of the group. The skew is not unexpected because loan-heavy and loan-only issuers tend to be of smaller scale and carry relatively high debt. The characterization aligns with our observation that 'BB' rated issuers have predominantly relied on the bond market to finance capital needs (see chart 1).

Chart 1

The top three sectors combined, health care (14%), consumer products (13%), and technology (13%), account for about 40% of the loan-only group on a count basis while oil and gas (16%); media, entertainment, leisure (14%); and mining and minerals (11%) dominate the bond-only group (see chart 2).

Chart 2

EBITDA interest coverage has stabilized, albeit at much lower levels than in mid-2022.

With profit growth decelerating and policy rates peaking at more than 5%, it's no surprise that median EBITDA interest coverage across the board has been drifting downward since mid-2022 (see chart 3 and charts 1a-1c in the Appendix for metrics on the aggregate sample). However, median coverage and cash flow for more leveraged loan-only issuers have declined to marginal from adequate, after having bottomed out to a coverage ratio of 1.6x at year-end 2023.

Companies have responded to softened sales by taking initiatives to boost profit margins and operating cash flows, such as renegotiating vendor and supplier contracts, optimizing inventory, or exiting lower-margin products or contracts. In addition, pricing efficiencies have played a role in differentiating performance, as some companies (those with a strong market position) have been able to hold onto price increases implemented in previous years, helping to offset any downward pressure on the EBITDA margins while others, including some retailers and restaurant chains, are offering more discounts or stopped passing on cost increases to consumers.

Our latest data for the 12 months through the first quarter of 2024 indicate some stabilization or even modest improvement in the coverage ratio. This is in part due to the modest level of rate hikes on a trailing 12-month basis and meaningful margin tightening from the refinancing and repricing boom in 2024. According to PitchBook LCD, approximately 29% of the leveraged loan asset class was repriced in the first half of this year, with an average spread reduction of 54 basis points. Coverage levels for bond-only and mixed issuers have also flattened out and improved slightly in recent quarters, albeit at much higher levels. Over this time, the gap between the bond-only and loan-only groups has increased to about 3x, up from the low- to mid-2x area in 2022.

The underlying earnings growth of loan-only issuers has held up reasonably well thus far despite limited financial flexibility caused by high leverage and the sharp run up in benchmark rates. Over the past few quarters, loan-only issuers as a group delivered the most EBITDA growth, mitigating the impact of steeply rising interest expenses. The solid growth of health care (median reported EBITDA growth of 3.4% between 2023 and the 12 months through the first quarter of 2024), and technology companies (1.4%) drove the loan-only group's outperformance. In contrast, bond-rich sectors oil and gas and mining and minerals were among the weakest, both experiencing an EBITDA contraction of negative 3.7% and negative 4.4%, respectively, over the same period. Admittedly, oil and gas companies face tough comparisons because their strong performance in previous years set a high bar.

Looking ahead, we see the potential for interest coverage to further improve in the remainder of 2024 and into 2025, contingent on our base case of easing monetary policy toward the end of the year. S&P Global Ratings expects the U.S. economy to expand by 2.5% in 2024 and 1.7% in 2025 and anticipates a total of 125 basis points in rate cuts by the end of 2025. That said, we expect that for select loan-only issuers with operational issues, the uplift from ongoing spread compression and upcoming rate cuts, when filtered through, may be subdued by cooling EBITDA growth momentum. We also believe that many of the challenges they face--such as managing a debt-laden balance sheet and operating with limited flexibility--are more structural than cyclical.

Chart 3

FOCF-to-debt metric in recovery mode

Managing FOCF has been a tough job on several fronts, not least because of surging debt servicing fees. Non-deferrable capital expenditure (capex) (coupled with costly financing options) and inflationary pressure (across nearly all cost categories--materials, labor, and freight) have further strained internally generated cash flow. At its trough, the median FOCF-to-debt ratio for loan only issuers dipped below 1% in 2022, more than halving from the previous year. Meanwhile, the median for small companies in the sample (defined as those with annual EBITDA of less than $100 million) remained consistently negative.

The FOCF-to-debt ratio has shown a firm progression in general since mid-2022 (see chart 4 and tables 2a-2c in the Appendix), aided by moderating inflation and curtailed investment plans (in fact, investment decisions are increasingly influenced by financing costs). On top of this, destocking or further normalization of inventory levels have allowed many to enhance FOCF.

Loan-only issuers, being the most exposed to rate hikes, began cutting capex in the second half of last year, ahead of others, and did so on a larger scale. This was reflected in their most-recent metrics improving ahead of the other two groups. However, the overall recovery of their FOCF-to-debt ratios still lagged the bond-only issuers, and we expect it may take well into 2025. We believe that additional cost optimization or deleveraging measures will be necessary for them to restore the ratio to historical levels. By industry, the business and consumer services and chemicals sectors had the most success in boosting FOCF to debt by cutting back on capex. In contrast, for the consumer products and forest product/building material/packaging sectors, future gains will be harder won.

Chart 4

Gross leverage plateaued

Median leverage has largely improved to levels lower than in 2019 for issuers rated 'B' and higher but remains stressed for lower-rated firms (see chart 5 and tables 3a-3c in the Appendix). The gap of median leverage between bond-only and loan-only issuers is 2.8x (6.3x versus 3.5x) for the 12 months through the first quarter of 2024. Although our analysts forecast ongoing deleveraging, if revenue and profit growth do not materialize as planned, or corporate investments or actions increase, such as aggressive debt-funded M&A and shareholder returns, we could see deleveraging slow down or even go in the other direction.

Chart 5

EBITDA Margins Expand

Below, we plot the industry median of interest coverage against FOCF to debt for the 12 months ended March 31, 2024, with straight lines representing cross-industry medians (see chart 6). Industries located in the lower left quadrant face higher risks than their peers, with weaker interest coverage and FOCF statistics. Specifically, the business and consumer services, chemicals, and health care sectors all had interest coverage consistently under 2x for the past few quarters. It is worth noting that all these sectors have managed to sustain or improve their FOCFs as a percentage of debt, largely through curtailing capex and working capital investments. On the other hand, the telecommunications and transportation sectors continued to burn cash and have shown little to no EBITDA growth.

Chart 6

Despite challenges at the top line, we see a relatively even distribution of margin expansions and contractions. Notably, 17% of entities reported an EBITDA margin expansion despite a revenue decrease. Of these, 11% were able to deliver higher EBITDA while the remaining 6% reduced EBITDA at a slower pace than their revenue decline, demonstrating effective cost rationalization. The capital goods and consumer products sectors stood out for achieving the highest EBITDA margin expansion despite experiencing a revenue decline (see chart 7 and table 1 for an illustration of the changes in revenue, EBITDA, and margin for the 12 months ended March 31, 2024, over the same period a year earlier).

Chart 7

Table 1

Recovery Prospects Of First-Lien New Issues Slumped

During the second quarter of 2024, which saw a significant increase in new issuance, investors continued to invest in 'B' and lower category-rated debt, with the share 4% higher than the previous quarter. The average recovery estimate for new issues remained at 61%, the lowest since 2017 (see chart 8 for quarterly trends of our recovery expectations for first-lien new issues measured by the average recovery point estimates).

New issues from distressed issuers accounted for about two-thirds of the bottom tiers (recovery ratings of '5' and '6', indicating less than 30% recovery in the event of payment default; see chart 9). The public debt exchange carried out by Missouri-based eye care service provider EyeCare Partners LLC is a recent example of how super-priority new money can diminish recovery for the legacy secured lenders. The company, in addition to obtaining a new, first-out super-priority term loan, exchanged its existing first-and second-lien term loans for new second-, third-, and fourth-out super-priority loans. We estimate zero recovery for the legacy debt given its now lower priority. Distressed debt exchanges typically provide essential near-term relief through cash interest saving and new capital infusion. They are meant to allow companies to execute their turn-around plans, albeit at the cost of greater debt and interest burdens in subsequent years.

Chart 8

Chart 9

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

Table 6a

Table 6b

Table 6c

Related Research

• Economic Outlook U.S. Q3 2024: Milder Growth Ahead, June 24, 2024
• U.S. Leveraged Finance Q1 2024 Update: For Most 'B-' Rated Issuers, Solid Businesses Have Shaky Finances, May 23, 2024
• Recovering From COVID-19: Why The Timing Of Bankruptcy And Emergence Matters For Debt Recovery, Feb. 7, 2022