The US junk loan market has been hit with a series of credit rating downgrades

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America’s $1.4 trillion market for risky corporate loans experienced its biggest series of cuts since the depths of the Covid crisis in 2020, as rising borrowing costs strained companies piled high with floating-rate debt.

The number of junk loan writedowns in the United States was 120 in the quarter ending in June and, according to an analysis by JPMorgan, was $136 billion — the highest total in three years.

Leveraged loans are issued by highly indebted companies with non-investment credit ratings, and usually have floating coupons that move with prevailing interest rates. Some of the US companies that have been downgraded in recent weeks include Aspen Dental Management, MedData and investment software company Confluence Technologies.

The declining credit quality of junk loans comes on the heels of the explosive growth of the market in recent years. Corporations and private equity backers took on this type of debt when borrowing costs were so low during the pandemic.

The asset class has ballooned far beyond the size of the longer-established high-yield bond market and has become a mainstay for riskier borrowers.

But companies now face the daunting task of paying back loans to lenders in an environment where interest rates have been much higher since the Federal Reserve started raising interest rates in March 2022.

“There is an immediate impact on the entire capital structure, the entire stack of debt obligations, once prices move,” said Steve Purdy, head of credit research at TCW Asset Management.

Rating downgrades mean companies have to pay more to issue new debt, as lenders demand a higher premium to compensate for the higher risk of default. It could also force the largest buyers in the market – compounds called collateralised loan obligations – to avoid some of the riskier loans.

Low-Rated Debt ($Billion) Vertical Chart Showing Rating Downgrades In The Us Junk Loan Market Has Accelerated

CLOs obtain loans, classify them into risk categories and sell them to investors in tranches. The top score is called “triple-A” and the bottom score is known as “Equity”.

If too many companies on the rating scale slip to triple C, they can make a preemptive switch within the CLO structure that potentially cuts cash flows down to the lowest “equity” category of investors, funneling money up the selective ranking.

CLOs have built-in defense mechanisms to manage risk in their portfolios, including a typical 7.5 percent cap on the amount of triple C debt they can hold.

Concerns about excess CC triple buckets could limit critical financing for riskier companies, possibly sending them toward higher-cost financing or heading toward default anyway.

CLO investors are carefully watching their exposure to loans rated just above C in the event of a downgrade, according to Kevin Wolfson, leveraged loan manager at PineBridge Investments. “I certainly think that will have an impact on the demand for those credits,” he said.

Many CLOs also go out of what are called “reinvestment periods,” which is the time frame in which they can invest in new debt — which can reduce loan demand more broadly.

The increasing pressures on the loan market contrast with the relative calm in high-yield bonds, with fixed coupons giving companies more time to adjust to a rising price environment. Analysts also said the shrinking junk market size, due to relatively low new issuances and the rise of issuers to investment grade, is helping to support prices.

The discrepancy between the credit quality of loans and bonds is also seen in default rates.

Ratings agency Moody’s said this week the loan default rate was 4 percent on June 30 — up from 3.7 percent in May and 1.4 percent a year earlier. By comparison, the default rate on junk bonds was just 1.7 percent in June, compared to 1.4 percent in May.

Six US borrowers defaulted on their debts in June, including kitchen appliances group Instant Brands and US telco TelePacific, which operates as TPx Communications.

“Healthcare and software are the two sectors that we think could see a rise in virtual activity,” Wolfson said, noting that “those sectors account for the largest proportion of the market trading at distressed levels.”

The likelihood of further cuts and defaults depends in part on the course of the broader economy and the Fed’s policy response.

Some analysts and investors tempered their expectations of an imminent slowdown, after encouraging signs of softening inflation and softer employment data. Goldman Sachs this week cut its probability of a recession in the next 12 months from 25 per cent to just 20 per cent.

“Unless you have a real, hard recession, I don’t expect a sudden spike in defaults,” Peters said. However, he added, “What’s somewhat perverse here is that if you have a soft landing, and prime rates stay high, a lot of these companies are going to struggle regardless — given the increase in interest costs.”

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