A 16-month upgrade cycle of credit ratings in the US leveraged loan market came to an end in June. With the macroeconomic narrative shifting dramatically, the ratio of ratings upgrades to downgrades—a closely watched measure that can potentially impact rating-constrained CLO investors and broader market credit quality—fell below 1.0x in the second quarter.
Looking at it from another angle, on a three-month rolling basis, the downgrade count of loan facilities in the S&P/LSTA Leveraged Loan Index exceeded upgrades by 1.3x. This is the first time ratings downgrades have outpaced upgrades since January 2021.
Should the pace of downgrades accelerate, history has shown elevated negative rating actions to be a precursor to rising defaults—albeit a short one.
As the above chart illustrates, a jump in the downgrade ratio in March 2020, at 11.4x to the pace of upgrades, preceded an increase in the default rate of the S&P/LSTA Leveraged Loan Index above its (then) 2.58% historical average.
Looking at the monthly numbers, downgrades accelerated in June. The 40 loan facilities in the index netting downgrades were the most since June 2020.
This brought the count of downgrades to 74 in the second quarter.
The 16-month stretch of positive bias for rating actions on loan facilities is overshadowed by the damage of the pandemic downgrade wave. LCD data shows that since January 2020, 918 facilities were downgraded through June 2022, versus 445 upgrades.
On a 12-month rolling basis there were 202 upgrades to 164 downgrades through June, for a ratio of 1.23x. By contrast, the ratio was 0.97x in the year-ago period, meaning in the 12-month calculation downgrades exceeded upgrades in June 2021.
Taking a final look at the overall quality mix of the leveraged loan market, while there’s been a significant improvement in the index in terms of the share of companies in the C band ratings category that carry a heightened risk of default, just one notch above, companies rated B-minus, now make up a record 28% of the index.
Thanks to the default wave of 2020 and the recent upgrade cycle, just 3.54% of companies in the loan index carry a CCC, CC, or C rating. At the pandemic highs of April 2020 this reached a staggering 11.17%. The post-Global Financial Crisis low for the C-rated share, at 2.54%, was recorded in March 2015, before the impact of ultra-low oil prices prompted a distressed cycle within energy sector credits.
Since January 2009, the C-rated share of the index has averaged 6.4%.
The improvement seen in fewer C-rated issuers, however, rests on the stability of the B-minus cohort which, thanks largely to increasing issuance levels in the lower single-B brackets, has ballooned in recent years. The record 28% B-minus share of the $1.4 trillion loan market, up from 9% five years ago, is now almost equal to the better-rated B flat cohort, at 29% of the loan index.
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