Tightening credit conditions and rapidly rising funding costs have placed renewed focus on leverage credit risk and what investors can ultimately expect to recover in the worst-case scenario of a default.
With that in mind, LCD is revisiting recovery prospects for debt facilities, breaking down the different industry sectors where losses can vary considerably.
A few key takeaways:
- Seniority is especially key in asset-rich sectors;
- Weighed by the 2001 crash, Telecom recoveries were among the lowest;
- Utilities historically see the highest recovery rates;
- A high concentration of riskier loans (those rated B-minus or lower) puts Software in focus.
Recoveries on defaulted bonds and loans are, of course, influenced by many factors, including the stage of the credit cycle, the collateral that’s available to be recovered, and the time taken to restructure.
In spanning 34 years, multiple economic/industry cycles and $1.2 trillion of debt defaults, S&P Global’s LossStats database provides context for how recovery rates may compare, from one industry to another, in future events of default. The LossStats model appraises recoveries by valuing the settlement received from holding an instrument through its emergence from default. Simply put, the recovery is based on the amount received in settlement, divided by the principal default amount.
More specifically, after the debt markets have had the opportunity to absorb and evaluate the defaulted instruments, the nominal recovery process prices recoveries by valuing at three possible points of reference: emergence from default, settlement and liquidity event.
For this analysis, LCD has used discounted recoveries, as opposed to nominal, to minimize the noise of restructuring time by discounting the nominal recovery back to the last date at which a cash payment was made on the pre-petition debt instrument, thereby creating parity among the recovery outcomes from various events.
That leaves us with the collateral that’s available to recover — a variable that is of particular importance when assessing recoveries. A creditor’s position in the capital structure (and therefore the priority waterfall of claims to the assets) is key, as is the collateral in question.
To the latter, the below chart details average recoveries for all debt instruments emerging from default across different sectors, discounted for time in restructuring. Here we chart the 25 industries with the largest number of observations in the LossStats recovery database.
The data is presented as the dollar value per $1,000 principal amount.
For reference, the average discounted recovery for all 5,437 debt instruments tracked for this analysis from 1987–2021, when combining all sectors, was 60% of face value, or $595 per $1,000 principal amount.
For the 25 industries with the most observations, or defaulted instruments, recoveries ranged between 49% and 83% of face value.
The Utilities sector, by far, has the highest recovery rate of all the sectors, at 83% of par, or $829.58. This sector, with 300 defaulted instruments, is also one of the top five in terms of observation counts.
Utilities has long shown a propensity for higher rates of recovery, and there are several reasons for this. As a regulated industry, where consumers always require services of electricity, water, etc., the value of the underlying asset is resilient.
Furthermore, per Morningstar’s Economic Moat Framework, regulated utilities generally own difficult-to-replicate distribution, transmission, and generation networks, where state regulators typically grant exclusive rights to charge customers rates that allow the utility to earn a fair return on the capital they invest to build, operate and maintain their infrastructure. However, in exchange, regulations setting these returns do so at levels that are also aimed at minimizing the cost to the consumer.
On balance, for the reasons stated above, the Utilities sector is defensive, or relatively immune to economic cycles.
A final point of note when it comes to recovery rates: The Utility issuers’ ability to add debt is often limited by regulation or secured bond indentures.
Dialing in
On the other end of the spectrum, Telecommunications has recovered just 49% of face value, on average, over the history of this dataset.
Fast-moving technological trends in this highly capital-intensive sector have brought decades-long credit challenges to the industry. Given this, Telecommunications has the largest sample size of defaulted facilities.
Unsurprisingly, the largest share of the default observations emerged during the 2001 Telecom crash, and the years following. When excluding obligors emerging from 2001–2004, the average discounted recovery jumps to 70%.
Oil & Gas and Retail – how bad was it?
More recently, two sectors that have undergone industry-specific challenges — Oil & Gas, and Retail — now present an opportunity to assess just how painful recoveries in those segments were.
Starting with Oil & Gas: The sector went through its own rolling default cycle following the winter of 2014-2015 oil price crash that culminated in a sustained, historic industry downturn. In fact, 62% of Oil & Gas concerns emerging from default in the 34-year history of the LossStats database did so from 2015 and onwards.
Focusing first on the post-oil price crash subset emerging from defaults between 2015 and the end of 2021, the recovery rate across all debt facilities averaged 70% of face value, or $697 per $1,000 of principal amount. Looking at the six-year period from 2009 to year-end 2014, Oil & Gas recovery rates averaged 84%, although the sample size is considerably smaller and is more heavily skewed toward bank loans, which are typically recovered at higher rates than high-yield bonds.
The difference in recovery rates can be explained by commodity prices. Recovery rates are, of course, heavily tied to the value of underlying assets, which in this sector track closely to underlying energy prices. To take oil for example, between January 2015 and December 2021, the NYMEX WTI Oil Price averaged $53 a barrel. Between January 2009 and December 2014 that average was $87 a barrel.
Across the full history of the LossStats data, Oil & Gas recovers, on average, 65% of face value across all debt facilities.
Possibly helping to mitigate the destruction from ultra-low oil prices from 2015 onwards is the growing prevalence of distressed debt exchanges, which typically restructure in much shorter time periods than restructurings implemented via bankruptcy proceedings, thus helping to preserve valuations. Within the sample from 2015 to 2022, distressed exchanges accounted for 63% of defaults. From 2009–2014, distressed exchanges made up only 47% of defaults, with the rest defaulting via bankruptcy.
To further the point on distressed exchanges, looking at all sectors and the full database history, instruments that defaulted through bankruptcy had a recovery rate of 52%, versus 78% for distressed exchanges.
Bargain hunting
Sector-specific imbalances are always a concern and Retail, too, saw its share of restructurings long before the 2020 pandemic lockdowns upended the record-setting bull market cycle. Retail defaults spiked in 2017 as heavily indebted companies reeled from well-flagged headwinds, including e-commerce competition and declining foot traffic. The industry was dealt another brutal blow, of course, by the Covid-19 pandemic, as prolonged store closures and declining economic activity resulted in a devastating loss of revenue.
Historically, the average discounted recovery for Retail is 55%. It also ranks as the third-largest in terms of observation counts for defaulted facilities.
As a generally asset-lite sector, retail companies are typically dependent on profitability and cash flow as a source of debt repayment, with this sector generally lacking the hard assets of commodities and manufacturing.
Buoying recoveries for Retail, however, is the capital structure, which tends to include asset-based revolvers or lines of credit. These structures can restrict a retailer’s ability to draw down on its credit when it is in distress, because it is subject to borrowing base requirements. In addition, pre-petition letters of credit and revolving credit facilities are frequently refinanced into debtor-in-possession loans, putting those lenders first in line to be paid with the rest of the DIP lenders.
When looking at more recent emergences from bankruptcy in the wake of the “retail apocalypse” of 2017, recoveries for all retail instruments jump to 73%. Here, the share of higher-priority term loans and revolving credit facilities among the sample is 72% when looking at obligors emerging between 2017 and the end of 2021. Through to 2016, loans and revolving credit facilities made up 45% of defaulted instruments.
Looking at the full history of defaults across all sectors, revolving credit facilities have an average discounted recovery of 84%. Next in the priority waterfall of payment, term loans recover at 73%, while senior secured bonds are at 66% and unsecured bonds are at 52%.
Narrowing this analysis, we know that seniority in the capital structure influences recoveries. But how does this play out, sector to sector?
Here we see that higher ranking instruments have proven their mettle where asset-heavy sectors are concerned. LCD’s analysis shows bank debt lenders (including revolving credit) to Steel companies recover 84%, on average, versus just 16% for unsecured bonds. For Automotives, bank lenders recover 82%, versus 37% for bonds.
With a high observation count for defaulted obligors, recovery rates across term loans and unsecured bonds are near parity for Utility companies which, as mentioned, can often be more restricted in their ability to load up on debt.
Technical default?
Next, we zoom in on the Technology sector where recovery prospects could, in time, become a focal point given that a staggering 24% of all outstanding leveraged loans rated B-minus and lower in the Morningstar LSTA Leveraged Loan Index back Software concerns.
Contributing to the low ratings quality, LCD data show that Tech companies leveraged up a whopping 7.2x to fund dealmaking in the sector, before the markets pulled back from risk amid the May sell-off. To put this number into perspective, the 10-year average for leverage taken on by companies to fund LBOs through year-end 2021 was 5.85x.
Going forward, the uncertain macroeconomic outlook has been a major hit to tech stocks this year, with high-growth tech names tumbling and valuations pulling back amid the volatility. As noted in the PitchBook Q3 2022 PE breakdown, the adjustment in valuations and increasing interest rates led to investor caution and a dip in IT deal activity. Indeed, the year-to-date IT deal count is down 24.4% compared with the first three quarters of 2021.
“More sell-offs in tech stocks could come as tech companies are likely to miss earnings estimates with inflation and a strong dollar dragging down their profits, while higher interest rates continue to diminish the value of future earnings,” PitchBook analysts said.
Investors are also signaling expectations of stress in loans backing Software companies. As of Sept. 30, 10% of loans in the Morningstar LSTA US Leveraged Loan Index priced below 80 cents on the dollar — an anecdotal measure of distress — backed Software companies.
This, coupled with the sector’s high concentration of lower ratings, brings cause for concern to default risk and recovery prospects.
By way of reference, Computers & Electronics — the designation for Technology for the LossStats analysis — has recovered 56% on average.
Boding well for the Software sector is its resilience during the last economic cycle. Technology crossed the 10% index share way back in 2016 following a spectacular post financial-crisis boom period (from just 3% at the end of 2008), and despite this massive growth spurt, defaults from the sector remain few and far between.
Since 2015, only six companies from the technology sector have defaulted on term loans tracked by the index. During the same period, 17 retail companies defaulted on loans, as competition from online retailers compounded the troubles of heavily indebted brick-and-mortar chains. Companies tied to the oil and gas sector, meanwhile, racked up 30 loan issuer defaults — the most of any sector — thanks the sharp decline and ongoing volatility in oil prices since 2014.
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