Borrowers from the riskiest rung of the single-B ratings band now account for the largest share of the $1.425 trillion US leveraged loan asset class, the first time that's been the case in the 25-year history of the Morningstar LSTA US Leveraged Loan Index.
Thanks to a persistently low interest rate environment that encouraged yield-starved investors to load up on low-rated loan debt, B-minus rated companies now account for a record 28.4% of the market. This has surpassed, for the first time, the share of better-rated, B-flat companies. The B-minus ratings level is the lowest at which new leveraged loans are typically issued.
The staggering migration to B-minus loans will be closely watched for its impact on collateralized loan obligations — by far the largest investors of institutional loans — which have self-imposed limits to hold no more than 7.5% of assets in triple-C rated debt. Beyond that, loans falling into the CCC excess amount will see a par value haircut for the purposes of calculating overcollateralization (OC) ratio tests.
The B-minus loans sit just one rung above the triple-C ratings band.
Furthermore, while the amount of triple-C paper — and the impact to CLOs — rests largely on the stability of this now record B-minus cohort, buying better-rated loans to increase the credit quality of portfolios (and meet WARF tests) in troubled times could become more challenging. The Weighted average rating factor (WARF) is a metric used to measure the credit quality of a CLO portfolio.
Turning back to the data, the following chart shows the dramatic increase in B-minus rated borrowers by both dollar amount and share. According to LCD, the amount of outstanding leveraged loans to borrowers rated B-minus is more than four-times the amount it was five years ago. As referenced by the Morningstar LSTA US Leveraged Loan Index, $405 billion of loans are backed by B-minus rated companies. This compares to $95.8 billion in September 2017.
Collectively, B-minus and B-flat borrowers made up a record 57% of the loan market at the end of August, up from 40% five years ago. During this time, the B-flat share has fallen to 28%, from 30%, and the broad double-B rating share to 23%, from 28%.
The share of loans backing companies with ratings in the broad triple-C cohort fell to just 3.4% in July, the lowest level since November 2015 and down significantly from a high of 10.6% by par amount in May 2020 amid a wave of pandemic-induced downgrades. The triple-C share rose slightly in August, to 4.0%.
Downgrades have played a role, of course, but issuance has been an even greater driver of this degradation of loan market quality.
On the ratings side, LCD data shows 963 facilities were downgraded between January 2020 and August 2022, versus 467 upgrades. On the issuance side, a record 46% of loans have come to market with a B-minus credit rating by at least one ratings agency so far in 2022. This unrelenting trend toward lower-rated issuance has accelerated after a record issuance year of 2021, when 40% of companies funding in the leveraged loan market were rated B-minus. This compares to 24% in 2017.
Featured image by R Mendoza/Shutterstock
This article originally appeared on PitchBook News
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