Credit rating downgrades sweep through US junk loan market

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America’s risky corporate loan market, valued at $1.4tn, is facing a surge of downgrades, the largest since the COVID-19 crisis in 2020. Rising borrowing costs are putting pressure on businesses burdened with floating-rate debt.

In the second quarter of the year, US junk loans experienced 120 downgrades, totaling $136bn. This is the highest number of downgrades in three years, according to an analysis by JPMorgan. Some of the US companies affected by these downgrades include Aspen Dental Management, MedData, and Confluence Technologies.

Junk loans, issued by heavily-indebted companies with low credit ratings, usually have interest rates that vary with prevailing rates. The credit quality of these loans has declined due to their rapid growth in recent years. During the pandemic, companies and private-equity backers heavily relied on this type of debt with low borrowing costs. As a result, the size of this asset class surpassed that of the high-yield bond market.

However, with the Federal Reserve raising interest rates since March 2022, these companies now face the challenge of repaying lenders in a high-rate environment. This has significant implications for their debt liability stack and entire capital structure.

Downgrades require companies to pay higher rates when issuing new debt, as lenders demand a bigger premium to compensate for the increased risk of default. Additionally, these downgrades may cause collateralised loan obligations (CLOs), the market’s largest buyers, to avoid the riskiest loans.

CLOs purchase loans, categorize them by risk, and sell them to investors in tranches. However, if too many companies are downgraded to triple-C, a protective switch within the CLO structure may halt cash flows to the lowest “equity” investors, diverting money to higher-rated investors. CLOs typically limit their exposure to triple-C debt to 7.5%.

Concerns about an excessive number of triple-C loans could limit crucial financing for riskier companies, potentially leading them to seek higher-cost funding or default.

CLO investors are closely monitoring loans rated just above triple-C in case of downgrades, which may impact demand for these credits. Furthermore, many CLOs are reaching the end of their reinvestment periods, reducing demand for loans overall.

In contrast, high-yield bonds have experienced relative stability. Their fixed coupons provide companies with more time to adjust to rising interest rates. The junk bond market has also decreased in size due to limited new issuance and an increase in issuers reaching investment-grade status, which has helped support prices.

The divergence in credit quality between loans and bonds is evident in their default rates. The loan default rate increased to 4% in June, while the junk bond default rate stood at 1.7%.

In June, six US loan borrowers defaulted, including Instant Brands and TPx Communications. Analysts predict elevated default activity in the healthcare and software sectors, as these industries have a significant portion of their market trading at distressed levels.

The likelihood of further downgrades and defaults depends on the broader economy and the response of the Federal Reserve. Some analysts and investors have become less pessimistic about an impending slowdown, following positive signs of decreasing inflation and softer job market data.

Despite these factors, companies may still face challenges due to higher interest costs in a stable economy with high front-end rates. This could lead to increased struggles for these companies.