Leveraged Loans

Leveraged loan downgrades outpace upgrades by fastest pace since covid default peak

December 6, 2022

Downgrades in the US leveraged loan market are outpacing upgrades at the fastest rate since the default peak of September 2020. Driving the downgrade wave is the typically defensive Healthcare sector, while in the recently pummeled Technology sector, Software drove the highest number of downgrades. The rare upgrades are from sectors that were among the hardest hit during pandemic downgrade cycle. 

More broadly, in the third quarter, the corporate credit rating of 74 facilities in the Morningstar LSTA US Leveraged Loan Index were downgraded, more than twice the number at the end of the first quarter. Given the 37 upgrades, the ratio of downgrades to upgrades in the third quarter was 2:1. This is double the ratio from the second quarter, when downgrades and upgrades were near parity.

S&P Global’s ratings actions have been more punitive to single-B rated companies over any other ratings bracket. In the third quarter, 41% of loans were downgraded from companies rated single-B flat, versus 19% from B-minus, 14% from CCC or lower, and 12% from CCC+.

On the upside, there was an increase in upgrades for companies rated triple-C or lower in the third quarter, to 14%, from 2% in both Q2 and Q1.

In the three months ending Sept. 30, nearly 50% of loan issuer upgrades came from B-flat and B-minus ratings.

Sectors among the hardest hit during the pandemic and in the corporate downgrade wave that followed have netted a larger share of upgrades over downgrades through Oct. 31 this year. Hotels, Restaurants & Leisure sector and the Entertainment sector saw a combined 28 upgrades against just five downgrades.

On the flip side, Healthcare-related sectors took a combined 26 downgrades, split between Healthcare Equipment & Supplies, Healthcare Providers & Services and Healthcare Technology. That was against just three upgrades.

The big-ticket items sector of Household Durables received only nine downgrades through the first ten months of the year.

Looking to Tech, Software drove the highest number of downgrades from a single sector (17). This was, however, against 13 upgrades.

Downgrades in the Tech sector come as high-growth names in the space have tumbled in stock markets this year, with valuations pulled back amid market volatility and the uncertain macroeconomic outlook. As LCD wrote in a Nov. 8 report titled, “Sector Spotlight: Default recovery prospects, by seniority, across industries,” a staggering 24% of all outstanding leveraged loans rated B-minus and lower in the Morningstar LSTA US Leveraged Loan Index back Software concerns.

Investors are also signaling expectations of stress in loans backing Software companies. As of Sept. 30, 20% of the 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% of face value on average in the 34-year history of the data.

At the facility level, downgrades outpaced upgrades for a fifth consecutive month in October, at 2.47x — the highest rate of downgrades over upgrades since the default peak of September 2020.

A final note for market risk: a jump in downgrade activity has proven a forward indicator for future defaults, albeit a short one. During the pandemic, the downgrade-to-upgrade ratio jumping to 11.4x in March 2020, from 3.8x the previous month, preceded an increase in the default rate of the Morningstar LSTA US Leveraged Loan Index above its (then) 2.58% historical average.

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