The count of Weakest Links—a demonstrated indicator of future potential default activity—increased for a second consecutive quarter as leveraged loan issuers increasingly grapple with tightening credit conditions and costlier financing terms.
Weakest Links are leveraged loan issuers rated B-minus or lower (excluding defaults) by S&P Global Ratings with a negative outlook or implication. The analysis is based on credits in the Morningstar LSTA US Leveraged Loan Index. However, if a credit exits the index, it remains in the Weakest Links universe until its rating is withdrawn or it defaults, or the issuer nets an upgrade or improvement in outlook to its corporate credit rating.
The number of at-risk leveraged loan issuers tracked by LCD increased to 148 in the first quarter, from 143 at the end of 2022. The first-quarter count compares to a multi-year nadir of 96 in June 2022, and the latest reading is the highest since December 2020 (248) while also rising above pre-pandemic levels at the end of 2019 (145).
With the increase, the Weakest Links’ share in the Morningstar LSTA US Leveraged Loan Index is 11%. Though nearly unchanged from the previous quarter following a rise in the underlying loan universe within this analysis, the share has climbed from 7% at the midpoint of last year.
The first-quarter increase in issuers populating the loan Weakest Links cohort comes as the number of restructurings — be that a distressed exchange or payment default — increased to 12.
All told, 118 of the 148 loan issuers in the March cohort were also included in December’s cohort.
The count with higher-risk triple-C and double-C ratings fell to 89 in the first quarter, from 93 at the end of 2022. Of the 12 issuers with D or SD ratings at the end of March (on a trailing twelve month basis), seven had triple-C or double-C ratings in the previous quarter.
Technical imbalance
Leading the ranks once again was the Technology sector (listed in this analysis as Electronics/Electric), accounting for 16% of the loan Weakest Links as of March 31, flat with its share at the end of 2022. Rising sector-level distress and the sector’s outsized share in the leveraged loan market are both factors in Tech’s prominence on the list. In the vulnerable category of triple-C ratings, 10 of the issuers are Tech names, with two companies, Exela Technologies and Diebold Nixdorf, currently on LCD’s shadow default list.
The Healthcare sector booked a significant rise in Weakest Link issuers, with its tally growing to 19 at the quarter-end reading, from an already elevated 16 issuers at the end of 2022. Twelve of these names fall into the triple-C category.
As an aside, soon after the March 31 cut-off, Elevate Textiles, also on LCD’s shadow default list, was lowered on April 6 to CCC, from CCC+, and its ratings were withdrawn. S&P Global cited heightened refinancing risk, reflecting market volatility and increasing interest rates, “which raises uncertainty around the company’s ability to refinance its debt on satisfactory terms.” Elevate’s $585 million first-lien term loan became current on May 1, 2023.
The moderate climb in Weakest Links comes as ratings downgrades outpaced upgrades of loans backing leveraged companies in the Morningstar LSTA US Leveraged Loan Index for a 10th consecutive month through March. The ratio was at 2.46x at the end of March, and stayed at that level in April. In February, the ratio of downgrades to upgrades reached 3.32x, the highest level since August 2020, which was just one month before the September 2020 default peak of 4.17% by amount.
A jump in downgrade activity, as the above chart shows, can be a forward indicator for future defaults — albeit a short one. During the pandemic, the downgrade-to-upgrade ratio skyrocketed to 11.4x in March 2020, from 3.8x the previous month, preceding an increase in the default rate of the Morningstar LSTA US Leveraged Loan Index above its then 2.58% historical average.
This downgrade activity has, along with post-pandemic new-issue supply, helped weaken the ratings quality of the Morningstar LSTA US Leveraged Loan Index. LCD data show 29% of the index was rated B-minus as of April 30, versus 23% rated B. This compares to 29% rated B and 25% rated B-minus just two years ago.
Meanwhile, the share of the Morningstar LSTA US Leveraged Loan Index rated B-minus or lower was at a record level of 36% as of April 30.
While the underlying metric of rising Weakest Links denotes potential for an uptick in distress and restructurings down the line, the rate at which Weakest Links became defaults has slowed dramatically in recent years due to extremely accommodating financing conditions in 2021 and the first half of 2022. Just 8% of 2021 year-end Weakest Links have defaulted so far.
However, the year-end 2019 cohort has not held up as well, with 27% of these borrowers defaulting in 2020, as risk appetite for lower-rated borrowers evaporated at the onset of the pandemic.
Featured image by pogonici/Shutterstock
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