The Growth Of 'B-' Has Been Supported By And Contributed To A Self-Supporting Feedback Loop

Over time, the U.S. speculative-grade market has seen a gradual increase in the proportion of issuers with a 'B-' rating. This proportion has reached new highs since about 2017, during a benign macroeconomic period with relatively few defaults (until 2020) and as more private equity-owned firms have entered the rated universe. We posit that ultra-low yields prompted by years of monetary stimulus as well as the growth and performance of the CLO market have created a feedback loop that allows for strong investor returns with relatively low risk. This has created more debt options for issuers via demand for leveraged loans (see chart 1).

Previously, increases in the proportion of 'B-' issuers have tended to coincide with economic downturns and increased downgrades ahead of larger default cycles (see chart 2). To date, markets have appeared very accepting of this much higher proportion of riskier credits.

Chart 2

'B-' Ratings Have Performed Well Over Time

Issuers rated 'B-' in the U.S. have experienced less credit deterioration over time through lower default and downgrade rates (see charts 3 and 4). While the 'B-' default rate remains high, following the same cyclical trend as the larger speculative-grade market, it has peaked lower with each subsequent default cycle . In fact, during 2020, the peak default rate for 'B-' was the same as the overall speculative-grade peak of 6.6% at the end of 2020.

Chart 3

The default and downgrade rates of issuers rated 'B-' are both significant for CLOs.. Most broadly syndicated loan (BSL) CLOs haircut the value of assets from 'CCC' rated obligors once they exceed 7.5% of the collateral pool. This haircut of "CCC excess" assets makes it more likely that the CLO's par coverage tests will fail and divert interest away from the CLO equity holders and (if things get bad enough) to the junior rated CLO tranches as well. That said, the combined default and downgrade rate of 'B-' issuers recently hit a 20-year low of 2.9% in the 12 months ended January (see chart 4). This has allowed for equity tranches of many CLOs to continue enjoying healthy returns given historically few new entries into 'CCC/C'.

Chart 4

At an issuer level, the stability of 'B-' ratings may be most notable through recent years' relative lack of downgrades. In fact, over half of all entities currently rated 'B-' in the U.S. started with that rating (see chart 5). Adding those that started with a 'B' rating accounts for about 83% of all issuers currently rated 'B-'. Less than 1% of issuers currently rated 'B-' started with an investment-grade rating and only 4% were upgraded from 'CCC'/'C'. Additionally, the current "age" (or time since first rating) of 'B-' issuers in the U.S. is about 1.75 years, which is slightly longer than the historical average of just under 1.5 years.

Chart 5

We expect much of this observed stability to continue (see chart 6). As of the end of March, the 'B-' population in the U.S. with a stable outlook hit its all-time highest proportion (85%)--even higher than the rate of stable outlooks for 'B+'/'B' issuers. This is not due to more positive outlooks for 'B+'/'B': Through March, the negative bias for 'B-' rated issuers was 6.2%, compared to 9.5% for issuers rated 'B+'/'B'.

Chart 6

Market Demand Has Been Particularly Robust

Over time, the share of 'B-' ratings in the speculative-grade total has increased. In addition, raw debt issuance--particularly of leveraged loans--at the 'B-' level has expanded even faster, especially since the COVID-19 pandemic and resultant monetary stimulus (see chart 7). Total 'B-' leveraged loan volume in the three months ended March 2021 reached a record $86 billion. Though a boon for issuers who generally were able to come to market at lower rates and secure longer maturities last year, some risks have unsurprisingly built up because of this spree. Much of the loan debt issued at the lowest rating levels since 2020 has come with historically low LIBOR floors, which may make these issuers more vulnerable to the quickly rising rates seen thus far in 2022, particularly if rates continue to rise.

Chart 7

Interestingly, much of this lower-rated debt is concentrated in a handful of sectors (see chart 8). The high tech sector has led the way, with roughly $100 billion in outstanding 'B-' rated debt, $88 billion of which is in loans. Prior to the global financial crisis, the high tech sector had the smallest proportion of issuers at 'B-' or lower. At 44.6% today, it is only 0.16 percentage points lower than chemicals, packaging, and environmental services, the leading sector.

Chart 8

CLOs Are Helping To Drive The Feedback Loop As The Dominant Buyer Of Leveraged Loans

As mentioned earlier, the feedback loop that has existed thus far for borrowers and investors has been supported by CLOs, which are the dominant buyers of leveraged loans (see chart 9). In recent years, CLOs have picked up around two-thirds to three-quarters of most newly issued loans, supporting their growth to what is now a $1.3 trillion asset class by outstanding debt.

Chart 9

CLOs have also seen strong growth in the past five years. Despite such a large proportion of their underlying assets carrying very low ratings, CLO notes have demonstrated strong rating performance: the power of collateral diversification as well as credit protections for the rated notes in CLO structures. Often comprised of loans from hundreds of individual issuers, defaults among the asset pool of most CLO portfolios have had little negative impact on the overall structure's chance of default. In fact, CLOs have been especially strong in terms of default remoteness (see chart 10).

Our criteria for rating CLOs is dynamic and responds to changes in the credit risk of the underlying CLO loan portfolio. All else being equal, our criteria would require greater credit enhancement (for example, higher subordination at a given rating level) for a collateral pool with more 'B-' loans.

Since 2001, the highest recorded annual default rate among CLO notes in the U.S. was 0.43% in 2002, which came alongside a speculative-grade corporate default rate of 7.25%. Even in the years following the global financial crisis, when the speculative-grade corporate default rate hit 11.8% in 2009, the CLO default rate peaked in 2011 at a mere 0.31%. In over half of the years observed, the CLO default rate was zero.

Chart 10

These factors have arguably contributed to a growing population of new speculative-grade issuers, the great majority of which are within the 'B' category and roughly one-third of which are rated 'B-' (see chart 11). This proportion of 'B-' issuers has skyrocketed since 2015, roughly in line with the expansion of leveraged loan issuance.

Chart 11

More often than not, issuers with low ratings tend to be smaller and/or more heavily leveraged. The strong performance of CLOs has supported continued investor demand, which has in turn supported strong demand for the underlying loans. Thus far, investors have benefited from the diversification effect and credit protections of CLO structures and the issuers of these loans have benefited from access to the institutional loan market, which may not have been as open to them previously. While this has certainly been a benefit for funding access and perhaps business and economic growth in recent years, it has not come without its risks.

All That Glitters May Not Be Gold…

'B-' ratings carry higher risk of default or downgrade than higher ratings--even if those figures have been trending down in recent years. Additionally, the riskiness of the underlying loans has been building for some time. The weakening ratings mix reflects a higher default likelihood than in 2016, roughly when this increase in 'B-' ratings began. Alongside building risk, underlying factors will also likely reduce recovery prospects in the event of a default.

Leverage and debt cushion are key factors that drive recovery rates on leveraged loans, along with whether or not a given loan is 'covenant-lite.' To start, nearly all new issue first-lien leveraged loans in the U.S. are covenant-lite, a growing trend in recent years (see chart 12). Covenant-lite term loan structures are term loans that don't have financial maintenance covenants. This reduces the ability of term loan lenders to negotiate with the borrower for tighter protections (or increased compensation) when a borrower's financial performance deteriorates from the expectations at loan origination.

Chart 12

Based on S&P's survey of 65 first-lien term loans that emerged from bankruptcy from 2015 to 2020, covenant-lite first-lien term loans recovered on average about 68% of par, over 10 percentage points below the 79% recovered by non-covenant-lite first-lien term loans. Additionally, looser covenants in credit agreements provide latitude for the issuers (or sponsors) in distress to raise liquidity--using the ample flexibility (to raise incremental debt, sell assets, etc.) that is widely present in broadly syndicated loan documents--which has consequences for the recovery rates of existing lenders.

Another consideration underlying recent loan structures is a relative lack of debt cushion for first-lien debt in recent years. To keep debt costs low, we are seeing heavy reliance on first-lien debt leverage (which is cheaper than junior debt) and thinner debt cushions in cases where junior debt was a part of the debt structure. In aggregate, higher debt leverage and shrinking cushions of junior debt suggest lower future first-lien debt recoveries given default relative to what we have observed historically, as more first-lien debt seeks recovery from the same collateral. This has already shown itself to be true since the pandemic (see charts 13 and 14).

Chart 13

Chart 14

The outlook for future recoveries continues to worsen based on these structural trends in recent loans (see chart 15). The average expected recovery has declined from over 70% in early 2017, recently hovering in the low- to mid-60% range.

Chart 15

Recovery expectations at the issuer level in North America have also been declining in recent years (see chart 16). Though not as pronounced as the fall in expected recovery rates on new issues, recoveries at the issuer credit rating level have been declining across nearly all rating levels. Combined with the increase in 'B-' ratings relative to the total speculative-grade population, this marks a clear decline in overall recovery expectations to complement the falling expectations on new issues.

Chart 16

…Some Tarnish Is Likely On The Way

Current and potential stressors could start to test these issuers soon, with the potential to slow this feedback loop if sustained. While we don't anticipate a major default wave in our current base case default rate projection, we do believe defaults will rise from their very low levels (to roughly 3% through March 2023, see "The U.S. Speculative-Grade Corporate Default Rate Could Reach 3% By 2023 As Risks Continue To Increase," May 19, 2023). As rates increase, we'd normally expect floating-rate loans to be very popular among investors. However, leveraged loan issuance is down roughly 30% from 2021, through April. The combination of growing recession fears, rising market volatility and CLO tranche spreads, along with the additional challenge for CLOs to adjust to a new interest rate (with the cessation of LIBOR) is presenting headwinds for new CLO issuance and therefore demand for leveraged loans. The cost of existing debt may become higher earlier for recent leveraged loan issuers as LIBOR floors on existing loans have fallen (see table 1). Combined with the current three-month LIBOR rate rising quickly this year and now at 1.5%, rising rates will arguably become a burden sooner than in recent years, which saw little in terms of rising rates.

Table 1

Related Research

• The S&P/LSTA Leveraged Loan Index Default Rate Could Rise To 1.75% By March 2023, June 6, 2022
• The U.S. Speculative-Grade Corporate Default Rate Could Reach 3% By 2023 As Risks Continue To Increase, May 19, 2022
• U.S. Recovery Study: Post-Default Recoveries Improve In 2021 As Challenges Remain, Dec. 15, 2021
• Settling For Less: Covenant-Lite Loans Have Lower Recoveries, Higher Event And Pricing Risks, Oct. 13, 2020