The leveraged debt markets, dominated by continuing growth of the syndicated loans in the U.S. and Europe, have wrapped up the most successful year in history, by most commercial standards. New issue volume is at record levels, defaults remain low by historical measures, and market liquidity continues to be strong, fed by sizable new sources, including cross-border flows. But from a credit perspective, the very success of the current market raises a striking and potentially troubling pattern; credit spreads at the lower end of the rating spectrum remain flat or declining even as 'B' and 'CCC' rated new issue volume ($131 billion in 2006, according to Standard & Poor's Leveraged Commentary & Data--sharply up from $87 billion in 2005) reached a level not seen before in traded leveraged credit markets.
This profile is not new, and Standard & Poor's has noted it since year-end 2004. But its persistence raises the question: Has the credit cycle been repealed? In this, as in other debt market expansions, some argue that new forces--including more effective portfolio risk management strategies, new structures for diversifying credit risk through credit default swaps and structured vehicles, and new sources of market liquidity--are combining to alter, if not repeal, the historical credit cycle. We conclude, however, that the credit cycle has not been repealed so much as deferred and potentially intensified, as current market liquidity leads at times to an indifference to key credit measures—and in the extreme, to a form of credit amnesia characteristic of expansionary debt markets. With default risk at unprecedented levels (as measured by credit ratings), focusing on post-default recovery prospects becomes all the more critical.
In December 2003, Standard & Poor's Ratings Services introduced its recovery ratings, which estimate the range of principal likely to be returned to lenders in the event of a borrower's default and are based on a fundamental analysis of key factors. These ratings are providing an extensive window into recovery prospects on leveraged debt originated during this period of record debt market expansion. Our ratings coverage has grown to nearly 1,800 secured debt facilities (and more than 3,000 tranches), amounting to more than $800 billion. We expect this number to exceed 3,000 in the next 12-18 months as we expand our assignment of ratings to unsecured and subordinated debt, and begin to include financial services, sovereign, and non-U.S. public finance issuers. We are also broadening our global recovery rating coverage, and plan to increase the weighting of recovery prospects into our traditional issue level default-risk ratings (see “Standard & Poor’s Proposed Changes To Recovery And Issue Ratings: An Update,” published Jan. 4, 2007).
Standard & Poor's Recovery Ratings
Rating
Analytical description
Indicative recovery expectation
1+
Highest expectation for full recovery of principal
100% of principal
1
High expectation for full recovery of principal
100% of principal
2
Substantial recovery of principal
80%-100% of principal
3
Meaningful recovery of principal
50%-80% of principal
4
Marginal recovery of principal
25%-50% of principal
5
Negligible recovery of principal
0%-25% of principal
Standard & Poor's assigns recovery ratings to new secured loans (and any secured bonds issued along with such loans) in the U.S., Canada, Europe, and Australia. While the majority of recovery ratings are currently assigned in the U.S., non-U.S. recovery ratings are growing rapidly, especially in Europe, where we have assigned more than 120 thus far.
Recovery Ratings Profile
Since their launch three years ago, recovery ratings have shown a pattern of wide dispersion. The average recovery rating in 2006 (through Nov. 16) was 2.7--not far from the 2005 and 2004 averages of 2.8 and 2.9, respectively, though standard deviation remained high, at 1.5. This dispersion in secured loans' recovery prospects was driven, in large part, by the rise of second liens, which accounted for approximately 80% of all recovery ratings rated '5' (indicating expected recovery value of less than 25% of principal in the event of default).
Chart 1
Chart 2
As we saw a year ago, sector-specific trends are not a chief driving factor in recovery, as other studies have found. We see only a weak distinction among industries, with average recovery ratings ranging from a high of 2.1 in the real estate sector to a low of 3.1 in high tech, and standard deviations showing a similar pattern across the board (see chart 3). But while there is generally a limited distinction among the sectors for which Standard & Poor's has assigned recovery ratings, some distinctive clustering of ratings near the top of the scale can be seen in the power, oil and gas, metals and mining, and real estate industries.
Chart 3
Chart 4
Default risk vs. recovery risk
We continue to see no material correlation between default risk (i.e., issuer credit ratings) and recovery expectations on secured loans. This lack of a relationship has held true consistently over the three years Standard & Poor's has been assigning recovery ratings. In large part, this is because debt in the secured loans are often structured to ensure greater recovery prospects as default risk rises.
As chart 5 shows, 13 loans to borrowers with a corporate credit rating of 'CCC+' or below--signifying a high potential for near-term default--carry a recovery rating of '1', indicating a high expectation for full recovery of nominal principal in the event of a default. At the same time, it is interesting to note that not all loans to borrowers in this rating category show this high recovery potential: Recovery ratings of '4' or '5', indicating the expectation for less than 50% recovery in the event of a default, were also assigned to 16 of those borrowers with default-risk ratings of 'CCC+' or lower.
Chart 5
Outlook
Overall recovery rates when the credit cycle turns--like with other short-term trends--remain particularly difficult to predict. But Standard & Poor's has identified some new factors likely to shape recoveries in at the next turn in the credit cycle.
New market entrants
The current market expansion has been driven significantly by new entrants into the leveraged loan market. Institutional investors have now substantially replaced banks as holders of leveraged loans. As a result, banks' historical focus (in post-default restructurings) on par recoveries has yielded to the institutional focus on market exit values, often driven by mark-to-market valuations. Moreover, for some institutions, such as hedge funds and structured CDOs controlled by hedge funds, loan recovery values have, at times, become less important than the opportunity to use debt terms and covenants as a means of gaining ownership of the borrower.
Rising complexity
The market expansion has also seen increased complexity in loan structures, with the advent of multiple secured liens, bifurcation of secured loan pledges, expansion of asset-based structures, and the growth of borrowing at multiple levels in the borrower's structure. In addition, many loans also involve multiple cross-border jurisdictions in which the collateral is located. This complexity has the potential to increase costs and extend the time required in potential restructurings. In response, some leveraged lenders have focused on simplifying lending structures before they are part of any participation in complex debt structures, in order to facilitate any potential renegotiations or restructuring that may be required should loans become distressed.
Conclusion
Seen through the window of recovery ratings, the current expansion has not changed some longstanding characteristics of secured loan recoveries evident in historical data. Industry profiles play only a limited role in shaping post-default recovery prospects (with a few exceptions), and the correlation between default risk and recovery prospects across the portfolio of secured loan recovery ratings is all but absent.
But recovery ratings also show that in the current expansionary market, post-default recovery prospects for Standard & Poor's rated secured debt are far from equal, with significant dispersion around average recovery values. This means that it is increasingly important to focus on specific recovery potential for individual loans, rather than relying on class-level assumptions about all corporate industrial secured loans. Standard & Poor's recovery ratings to date--and our extension of them to other sectors and to unsecured levels of the capital structure--are designed to address these instrument-specific recovery prospects. For many lenders and borrowers, this focus may be one of the best ways to prepare for any turn in the credit cycle.
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