S&P reduces recovery forecasts for bonds

Standard and Poor’s has reduced recovery expectations on certain bond issues despite price tightening.

The European Central Bank’s (ECB) interest rate cuts made earlier this month will only exacerbate investors’ search for yield and could lead to looser lending standards, Standard & Poor’s warned on Thursday.

The supply-demand imbalance in the European leveraged loan market, which is seeing a rising amount of capital chasing a decreasing number of deals, could contribute to excessively borrower-friendly lending standards and more highly leveraged transactions, trends it is already starting to observe, it said.

The rating agency also observed structural changes in leveraged finance funding, in conjunction with the rise of secured bond financing, and has decreased its recovery expectations for bonds linked to certain capital structures as a result.

In the first edition of a new quarterly leveraged report titled, “As The European Market Heats Up, Recovery Prospects For Senior Secured Bondholders Cool,” the ECB’s unconventional measures to tackle deflationary pressures and boost bank lending will likely further tighten pricing on high-yield debt and intensify the appetite for speculative grade debt, S&P said.

The average yield on debt rated BB+ or lower has already tightened significantly in the past year and a half, with an average yield for B rated companies compressing to 6.1 percent in the six months to 6 June 2014, from 8.3 percent at the end of 2012.

Besides tighter pricing, S&P has observed structural changes in leveraged finance funding, namely the use of secured bond financing to refinance existing bank debt and hybrid transaction structures. As a result, S&P has reduced its recovery expectations for some of these bonds.

Taron Wade, analyst at S&P commented, “We see two reasons for this: First, companies are using bonds in a different way. In 2009 and 2010, firms mainly used senior secured bond debt to refinance existing senior secured loan debt on a pari passu basis. Over the past 12 months, however, the more common use of senior secured debt issuance is to refinance entire debt structures – typically with a super priority revolving credit facility (RCF) ranking ahead of the new senior secured debt.

“Second, the quantum of senior secured debt relative to the entire capital structure has increased as a result of refinancing, which affects expected recoveries post-default, particularly where stressed valuations are low.” 

Recovery ratings for all senior secured bonds have fallen to between '3' (50 percent – 70 percent recovery of principal) and '4' (30 percent -50 percent), compared with '3' in 2010 and '2' (70 percent – 90 percent) in 2009.