Corporations worldwide have taken on even more debt in the first and second quarters to help manage an ongoing working capital crisis brought on by the coronavirus pandemic. CreditRiskMonitor® reported in April that the FRISK® score demonstrated the most individual company downgrades since the Global Financial Crisis. Then in June, S&P Global Market Intelligence indicated that the U.S. leveraged loan downgrade ratio reached 43:1, nearly 5x the severity of the peak of the Global Financial Crisis.
The U.S. leveraged loan market, the fastest-growing segment of the credit market over the last decade, has reached $1.2 trillion. The largest subset of that category is the collateralized loan obligation (CLO) market, which hit a record $690 billion. In the first quarter, however, CLO issuance declined by 48%, according to Reuters, and continued to remain tepid in the second quarter. When credit issuance stalls like this, the prevailing wisdom is that institutional investors will have less of an appetite for these risky special purpose vehicles.
Watching FRISK® Downgrades
CreditRiskMonitor® provides commercial credit report coverage spanning more than 57,000 public companies worldwide, many of which have a presence in the leveraged loan market. The 96%-accurate FRISK® score evaluates financial risk by providing a statistical probability of bankruptcy risk looking out over a subsequent 12-month period. The FRISK® score uses a "1" (highest risk)-to-"10" (lowest risk) scale, with the “1”-to-“5” category being the “red zone.” When a company’s score descends lower into the red zone, its risk of bankruptcy meaningfully increases. The coronavirus has caused serious damage to corporate credit quality, leading to a substantial climb in red zone companies:
Among the five score groups, the FRISK® score of “1” originally demonstrated the largest increase, which transpired during the first wave of bankruptcy filings in March and April. With that wave now past, the FRISK® score “3” category (denoted in yellow) is now the largest growth category, increasing in size by 35% since January. Companies that carry a FRISK® score of “3” have a 2-to-4x higher risk of bankruptcy compared to the average public company. For reference, the FRISK® score scale is shown below:
Faltering Risk Appetite
Leveraged loan quality standards are at their lowest in history. Recent estimates indicate that approximately 85% of the entire leveraged loan market and 90% of the European leveraged loan market are covenant-lite. Covenant-lite loans indicate that lenders have limited protections. The most common lacking provisions are maintenance covenants, such as quarterly maximum leverage and interest coverage ratios. Without such restrictions, issuers have been able to borrow more aggressively than they would normally be allowed. This dynamic puts unsecured bondholders and trade creditors at a disadvantage relative to other layers of the debt stack. Today, the vast majority of leveraged loans are rated single B, a category that is considered speculative and subject to high credit risk.
The typical corporate debt capital structure priority starts with credit lines and secured term loans, which are often secured by cash, receivables, and inventory, among other assets. These two credit classes are primarily where CLOs are originated. After that are the secured notes and unsecured obligations, such as mezzanine, convertibles, payables, etc. as shown below:
When buying CLO securities, banks, pension funds, and insurers will generally focus on AAA-rated or AA-rated credit tranches. However, when any of the tranches don’t receive full recoveries, the appetite for this market becomes challenged, which is exactly what is transpiring today. One Japanese bank, which owns more than 10% of the entire U.S. CLO market, said it would no longer be making purchases after incurring losses caused by the coronavirus pandemic, according to The Wall Street Journal. Other banks will arguably fill that void but run the risk of overextending credit exposures and absorbing future losses. Moreover, the question remains about which institutional funds will bear the risk of even lower-rated segments of the CLOs, particularly the BB-rated and equity tranches that have been subject to fractional waterfall payments.
CreditRiskMonitor® has forecasted that the U.S. non-financial corporate debt default rate will exceed 13% by 2021. That spells trouble for leveraged loans and junk bonds alike. Given that corporate financial leverage is higher than any other recorded period, recoveries will likely be below historical averages.
The bankruptcy tally has rapidly grown year-to-date and the FRISK® score correctly identified those that are most vulnerable. In every case, the FRISK® score provided adequate warning with most falling deep within the red zone up to a year in advance of the bankruptcy filing date. The 10 companies shown below each carried noteworthy term loan balances, which were assimilated within the CLO market.
|Company||Term Loan Amount (in Millions)||Bankruptcy Date|
|Foresight Energy LP||$743||Mar. 10, 2020|
|Whiting Petroleum Corporation||$2,182||Apr. 1|
|Quorum Health Corporation||$738||Apr. 7|
|LSC Communications, Inc.||$219||Apr. 13|
|Frontier Communications Corporation||$1,694||Apr. 14|
|J.Crew Group Inc.||$1,348||May 4|
|Neiman Marcus Group LTD LLC||$2,175||May 7|
|J. C. Penney Company Inc.||$1,540||May 15|
|Hornbeck Offshore Services, Inc.||$471||May 19|
|Hertz Global Holdings, Inc.||$727||May 22|
Term loan amounts exclude all other debt of each respective company.
Despite the fact that term loans are among the highest in repayment priority, some ended up realizing poor recoveries. For example, Foresight Energy LP’s term loan traded approximately 93% below par value directly before it filed for bankruptcy, an indication that its apportioned collateral was nearly worthless. Whiting Petroleum, which carried more than $4 billion in tangible equity before bankruptcy, saw its term loans selling for 80% below par value. J. C. Penney Corporation Inc.’s advisor, Kirkland & Ellis LLP, valued its unencumbered real estate assets to be about $1.4 billion and yet its term loans exchanged hands at 60% below par. These bankruptcies show that collateral asset values have degraded across multiple industries.
Risk professionals need to be aware of cracks in the leveraged loan market given it represents the primary channel of debt financing for many large public companies. It allows them to fund mergers and acquisitions, sustain and reinvest in operations, and facilitate payment of their bills – all pivotal matters for those in the functions of credit and supply chain.
With more FRISK® score and credit rating downgrades transpiring compared to the Global Financial Crisis, it’s inevitable that more public company bankruptcy filings are on the way. Institutional investors and CLO managers have reigned in their appetite for incremental leveraged loan issuance and corporate borrowers are bearing the brunt of this fallout. Corporations that will be most impacted are among the FRISK® score “1”-to-“5” category or similar correspondent “B” and “CCC” rated debt issuers. CreditRiskMonitor® recommends mitigating risk exposure before more bankruptcies unfold, as public companies release second quarter filings that will reveal more pronounced balance sheet deterioration.