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Macro

Middle-Market CLOs' Credit Quality Dips, Moody's Reports

Moody's reports worsening credit quality in $1.7 trillion private credit market, signaling stress and potential losses.

By Barry Stearns

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5/8, 12:17 EDT
S&P 500
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Key Takeaway

  • Moody's reports a significant deterioration in the credit quality of loans in middle market CLOs, with a quarter downgraded.
  • Elevated interest rates pose refinancing challenges for over 20% of corporate borrowers in these CLOs.
  • S&P Global Ratings also observed more downgrades than upgrades in private credit CLO loan estimates for Q3 2023.

Stress in Private Credit Market

The private credit market, currently valued at $1.7 trillion, is facing significant challenges due to persistently high interest rates. Moody's Ratings has reported a deterioration in the credit quality of smaller companies, with about a quarter of loans in middle market collateralized loan obligations (CLOs) downgraded between the second half of 2022 and 2023. This trend is indicative of the broader stress within the market, affecting borrowers and lenders alike. Notably, large direct lending funds managed by firms such as BlackRock Inc., KKR & Co., FS Investments, and Oaktree Capital Management have seen their credit rating outlooks shift from stable to negative. This shift is largely due to an increase in loans on non-accrual status, which signals potential losses on these investments. Furthermore, the rise in payment-in-kind loans and questions about portfolio valuations underscore the eroding asset quality within the sector.

Leveraged Finance Market Dynamics

The leveraged finance market is undergoing a significant transformation, with healthier companies opting to refinance their private credit debt through cheaper bank-originated loans. This shift has left direct lenders with a portfolio of increasingly weaker and smaller companies, forcing them to accommodate more on price, terms, and provisions. Moody's highlights this period as the most competitive in the history of the leveraged finance market, with terms at their weakest. Ana Arsov, global head of private credit at Moody’s, pointed out the potential distress indicated by companies refinancing from the syndicated market to private credit, emphasizing the competitive pressures and the concessions being made by lenders to secure deals.

Investor Sentiment and Market Risks

Investor complacency amid narrowing spreads poses significant risks in the corporate credit market. The yield premium for owning US high-grade corporate debt over government bonds has fallen to a two-and-a-half-year low of 85 basis points, well below the five-year average. This compression of spreads may lead investors to underestimate the rising corporate credit risk. Moody's warns of a potential resurgence in market volatility that could prompt a sharp reassessment of risk premiums, significantly impacting credit portfolios. The market's disregard for potential volatility and credit risk is seen as a looming threat that could have profound effects on credit portfolios, highlighting the need for vigilance and a reassessment of risk strategies among investors.