The U.S.

Leveraged Finance Market Chugs Along Despite Risks

Leveraged Finance & Recovery: Andrew Watt, CFA, Managing Director, New York (1) 212-438-7868; andrew_watt@standardandpoors.com

Table Of Contents
Brisk Spec-Grade Issuance Has Prevailed So Far This Year Recent Spec-Grade Credit And Recovery Rating Trends Future Recovery Levels Could Wane Current Pricing May Not Reflect Risk Related Research

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After a short period of turbulence in the U.S. leveraged finance markets, renewed investor thirst for yield is once again sustaining solid issuance of speculative-grade nonfinancial corporate debt (rated 'BB+' or lower)--at least for the time being. Speculative-grade issuance was remarkably strong in the first half of last year, reflecting investor appetite and greater confidence in corporate credit quality. The market then hit a turbulent patch that lasted a few months--a fairly common occurrence in leveraged finance, where stretches of high volatility and shrinking capital market access often mark periods of robust issuance and market demand. In this light, Standard & Poor's Ratings Services expects fragile conditions to continue in the U.S. corporate credit markets. This is especially true for speculative-grade borrowers, as their reliance on an economic recovery and funding from the capital markets is more pronounced than it is for investment-grade issuers (those rated 'BBB-' or higher). Concerns about the condition of the global banking industry are compounding the challenges associated with stubbornly high unemployment in the U.S. and recessionary pressures in Europe. Meanwhile, U.S. economic growth is sputtering, with GDP growing at an annual rate of just 1.5% in the second quarter. Our cautions regarding credit are tied to the ability of U.S. companies to withstand an extended period of sluggish economic growth, along with revenue and operating margin pressures. Overview Speculative-grade debt issuance has been strong overall thus far this year. Standard & Poor's credit and recovery rating trends are generally stable, but skew slightly negative. Though not reflected in pricing, credit risk remains in the leveraged finance market considering the current fragile state of the economy.

Brisk Spec-Grade Issuance Has Prevailed So Far This Year

Despite the economy's slow growth, speculative-grade nonfinancial corporate debt issuance continues apace, with more than $175 billion reaching the market in the first seven months of 2012, according to S&P Capital IQ Leveraged Commentary & Data (LCD). That just about matches the same period of 2011. Again, we rate a majority of this debt in the 'B' category (including 'B+', 'B', and 'B-' rated debt) or below. The current corporate credit environment is seemingly comforting investors, as default rates for speculative-grade borrowers look set to remain at relatively low levels into next year. The base forecast from Standard & Poor's Global Fixed Income Research calls for a default rate of 3.6% from April 2012 to March 2013--essentially flat with 2011. Also, spreads over benchmark interest rates on speculative-grade debt aren't markedly different from those in the first half of the year. We have seen a trend of weaker credit-protection standards--specifically, so-called "covenant-lite" transactions, in which lenders impose fewer demands on borrowers' repayments--which substantiates the view that

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investors are searching for higher yields.

Recent Spec-Grade Credit And Recovery Rating Trends

Slightly more than three-fourths of Standard & Poor's speculative-grade credit ratings on nonfinancial corporate issuers carry a stable outlook. However, there is a bit of a negative tone, as 15% of these rating outlooks are negative while just 5% are positive. In addition, downgrades among speculative-grade borrowers outpaced upgrades at a 1.3-to-1 clip in the first seven months of the year. This is in sharp contrast to the investment-grade arena, where upgrades outpaced downgrades by nearly 4 to 1. Our recovery ratings (which estimate the ultimate nominal recovery of principal and past-due interest recovery for creditors in the event of a speculative-grade borrower's payment default) have shown a similar negative trend year to date. Negative recovery rating revisions have outnumbered positive revisions by a 1.3-to-1 ratio, and negative recovery rating actions have accelerated over the past few months (see chart 1). However, the pace of overall recovery rating revisions has not dramatically changed, as we have revised fewer than 10% of our more than 5,000 recovery ratings between June 2011 and June 2012. We assign recovery ratings on a scale ranging from '1+' (indicating our highest expectation of full recovery) to '6' (indicating negligible recovery).
Chart 1

Secondary market prices generally correlate with our recovery expectations, though over the past few months there

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has been a greater discrepancy at the very low end of the rating scale relative to average secondary spreads. Secondary spreads tracked by Standard & Poor's Leveraged Commentary & Data for loans with recovery ratings of '1' continue to be more than 800 basis points (bps) narrower than those for loans with a recovery rating of '6' (see chart 2).

Our recovery ratings continue to reflect two main themes: the debt's position in a borrower's capital structure and the significant dispersion of recovery estimates within each of the two most common positions--senior secured and senior unsecured debt. Recovery ratings on senior secured first-lien loans continue to skew toward the upper end of our ratings distribution and indicate our expectation for substantial recovery (about 75% on average) of principal and past-due prepetition interest in the event of a default (see chart 3).

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Chart 3

By contrast, recovery ratings on senior unsecured debt generally fall at the lower end of the distribution, and indicate our expectations for modest recovery (about 38% on average) of principal and past-due interest (see chart 4).

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Chart 4

We note that our recovery ratings on both first-lien and senior unsecured debt are widely dispersed within each class, with more than 65% falling outside the range of the average recovery rating for each class. Recovery ratings on subordinated debt, meanwhile, remain clustered at '6' (see chart 5).

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Chart 5

Future Recovery Levels Could Wane

A comparison of actual historical recoveries with our current recovery ratings indicates that for most classes of debt, average future recoveries may be lower than recent previous recovery levels--and lower than average recoveries in Standard & Poor's LossStats database from 1988 to 2011. We base this expectation on the following factors: Rising levels of secured debt. Speculative-grade borrowers are generally carrying more secured debt and higher levels of asset-based loans, which effectively rank ahead of senior secured loans in most insolvencies. The growth of split collateral pledges. Our portfolio of speculative-grade secured loans and bonds includes a growing number of issues in which separate lending groups split the same collateral. In a default, these split pledges have the potential to increase the time and cost of the insolvency process, and thereby could reduce recoveries.

Current Pricing May Not Reflect Risk

Either way, our outlook for leveraged loans and bonds is mixed. Market pricing of credit risk has remained relatively stable for higher speculative-grade issues (in the 'BB' and 'B' categories), and even for issues in the 'CCC' category. In fact, pricing in the U.S. is so attractive relative to conditions in Europe that some European borrowers have turned to the U.S. market to get new loans. From a fundamental credit perspective, however, our outlook continues be cautious, considering speculative-grade issuers' high exposure to the risks associated with slow economic growth and difficult

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macroeconomic conditions.

Related Research
Special Report: The U.S. Leveraged Finance Market Chugs Along Despite Risks, Aug. 13, 2012

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