Executive Summary
- With the US leveraged finance markets firmly back in business, we provide an updated look at interest coverage trends in the US HY market, using a range of EBITDA growth trends to stress test forward coverage levels at recent borrowing costs.
- In general, we find that the trajectory of interest coverage indicates reasonably solid credit quality across the HY market, though CCC coverage levels are likely to be more volatile and highly influenced by rebalancing of constituents.
- We find that BBs have the most near-term downside in coverage levels, with our model forecasting a dip below long-term median levels in 2024/2025. By contrast, Bs have posted better EBITDA trends in recent quarters, resulting in somewhat elevated interest coverage going forward (assuming still positive EBITDA growth).
In a recent note, US COTD: Sensitivity Testing HY Coupons, we examined HY coupon levels in aggregate and by rating assuming a range of borrowing cost scenarios. Not surprisingly, CCCs faced the most upward pressure on coupon levels given a higher proportion of near-term maturities. We take the next step in this analysis, looking at recent interest coverage trends across the US HY market, using a range of EBITDA growth trends to stress test forward coverage levels at recent borrowing costs.
As of 4Q23, US HY aggregate interest coverage was 4.6x, marking the third consecutive quarter of 4.5x-4.6x interest coverage. Despite this recent stability, HY market coverage has declined a full turn from a recent peak of 5.6x in June 2022 as HY issuers benefited from better-than-expected EBITDA growth and ultra low borrowing costs, driving a refi boom in 2020-21. The key factors impacting forward interest coverage levels include 1) potential EBITDA growth; 2) the increase/decrease in HY debt outstanding; and 3) borrowing cost trends. Over the past 12 months, EBITDA growth has decelerated meaningfully, to an average YoY increase of +0.9% over the past four quarters. With this, debt levels have actually decreased, both at the issuer level and at the index level, with the median debt balance declining by -0.4%, on average, over the past year. The combination of still positive EBITDA growth with declining debt balances has helped to mitigate the uptick in interest expense driven by higher borrowing costs, leaving interest coverage levels a full turn higher than the long-term median of 3.6x.
To stress test forward interest coverage levels, we assume that HY borrowing costs hold around recent new issue levels of 8.3%, a material step-up from the average index coupon of 6.1%. Though the HY market has been shrinking (US HY: The Incredible Shrinking Asset Class) in recent years, we assume a return to modest growth of 1% annually. We use three core EBITDA growth scenarios as the basis for our sensitivity analysis: 1) the long-term (since 1996) average of 6.4%; 2) a more bearish scenario where EBITDA is flat; and 3) the recent 5Y average EBITDA growth of 4.7%. Given our assumption that debt outstanding grows at a slower pace than EBITDA in two of our scenarios, we find that interest coverage levels stabilize around current levels or begin to improve, ultimately reaching a new high in 2033-2034 of 5.8x. By contrast, in our more bearish scenario that assumes flat EBITDA growth while borrowing costs and debt outstanding both continue to increase, interest coverage remains on a firmly downward trajectory, falling to 3.0x in 2032-2033. Even in this scenario, interest coverage does not fall below the long-term median until midway through 2028.
Interest Coverage Sensitivity Analysis by Rating
BBs
As with the broader HY market, BB interest coverage has declined in recent quarters, to 5.7x, which is just 0.1x above the long-term median level. The change in interest coverage is partially attributable to the rise in borrowing costs, but also a product of the wave of rising star upgrades that have materialized over the past two years as companies with IG-like credit metrics have moved out of the BB index and into IG/BBBs.
For BBs, we also assume that debt outstanding continues to grow at 1% annually and use a new issue coupon of 7.6%, more than 200 bp higher than the current index coupon of 5.5%. Historically, BBs have enjoyed stronger EBITDA growth than the aggregate market, with a long-term average of 8.6% and a 5Y average of 6.4%. Given the massive uptick in borrowing costs for BBs, interest coverage remains on a downward trajectory and was just 0.1x above the long-term median of 5.6x as of YE 2023. In the near-term, BB interest coverage appears likely to continue to move lower across our three scenarios as the recent rise in borrowing costs and continued index growth assumptions weigh on coverage levels. We also note that EBITDA growth for the past few quarters has been in negative territory for BBs, leaving a lower base from which to grow in the coming years. In a scenario where EBITDA growth follows the recent 5Y trend, BB interest coverage effectively plateaus just below the long-term median level, but holds above 5.0x through 2034. This would mark a downdraft from the post-GFC era, but is still meaningfully higher than the late 1990s/early 2000s. We note, however, that potential fallen angel downgrades and continued rising star upgrades could materially impact aggregate interest coverage levels for BBs going forward (see our BBB/BB Crossover Monitor: 1Q24 for a list of potential upgrade/downgrade candidates over the next ~12 months).
Bs
For B-rated issuers, interest coverage levels have moved sharply lower in the past two years, declining to 3.5x as of 4Q23, almost 1.5x lower than the recent peak of 4.8x in 1Q22. This is still slightly above the long-term median level of 3.3x, leaving Bs with some modest cushion to absorb higher borrowing costs.
After a wave of downgrades and issuance resulted in a material uptick in B-rated index growth in 2021, the index has returned to its more recent trend of very sluggish growth. Since 2015, the B index has grown at an average annual pace of +0.3%, slower than our assumed 1% growth rate in our analysis. Recent B-rated new issue coupons have average 8.5%, above the current index level coupon of 6.5%. While B-rated EBITDA growth has been lower than BBs, on average, Bs have posted more stability in YoY changes in EBITDA in recent quarters, holding in positive territory. This allows for B interest coverage to move higher in two of our three scenarios, which use the historic average growth rate of 6.5% and the 5Y average of 5.1%. In these two scenarios, interest coverage begins to move higher in the near-term and continues on an upward trajectory, remaining well above long-term median levels. In our bearish scenario that assumes flat EBITDA growth, interest coverage falls below the long-term median in 2026-2027 and moves toward the late 1990s/early 2000s level of ~2.5X by 2032.
CCCs
The lowest rated cohort of the HY market tends to post the choppiest credit metrics as the small constituent set is more influenced by index rebalancing related to defaults/upgrades and changes in metrics for very large issuers (we attempt to smooth the impact of bigger issuers by using median, rather than averages). With this context, CCC interest coverage has moved up and down in recent years, peaking at just over 2.5x in 2020 (likely due to downgrades) and again in 4Q23 (likely due to defaults and index rebalancing).
As with the B index, CCCs have been growing at a very sluggish pace of +0.3% annually since 2015. For purposes of our analysis, we assume that the CCC market shrinks by 1% annually on a combination of defaults removing issuers from the index and cuspier/stressed companies moving into the BSL or private credit markets, which have proven more receptive to more storied names. We also find that EBITDA growth for CCCs has proven very challenging, historically averaging -0.8% YoY in the long-term and -6.0% over the past five years. This leaves our flat EBITDA scenario as the most positive outcome for CCC interest coverage going forward. We note that the assumed 9.1% new issue coupon for CCCs is likely not representative of the entire market’s ability to raise new capital as only a handful of CCC deals have priced since the beginning of 2023 with higher quality CCCs enjoying better access to the HY bond market. While our forward analysis shows relatively stable interest coverage trends for CCCs, we expect that credit metrics for the rating cohort will likely prove more volatile (as they have historically).
Winnie Cisar, CFA
Global Head of Strategy
CreditSights
Zachary Griffiths, CFA
Head of IG & Macro Strategy
CreditSights
Brian Perez
Analyst, Credit Strategy
CreditSights
Kathleen Tang
Analyst, Strategy
CreditSights
