Warning signs flash as B3 share of loans reaches record level

Hugh Minch

Senior reporter

Credit analysts are sounding the alarm as the portion of the loan and high yield universe rated B3 or B- surged to a record level in the third quarter. Around 30% of the outstanding loan market rated by Moody’s had a B3 rating, while 60% of the new issue market targeted a B3 rating during the first nine months of 2022.

The expansion of B3 loans in portfolios is a growing concern for investors as interest rate rises continue to put pressure on company cash-flows.

Neha Khoda, head of loan strategy at Bank of America, says the impact of higher debt costs hasn’t yet been seen in corporate loan issuers’ financial statements.

“Q3 will be the first period where the loan index will have to pay more than its average floor, so it will be the first time you’ll see meaningful impact on coverage ratios from the point of view of debt service costs,” she says.

Khoda’s team undertook analysis of the accounting statements of issuers amounting to $1.5 trillion total outstanding debt and found that while B3 and triple C loans have around 1.5 times ebitda coverage, these companies have less than one times free cash-flow coverage.

“B3s are going to see close to 25% of their free cash-flows evaporate”

Neha Khoda, Head of loan strategy | Bank of America

“As it is, even before the impact of interest rates, these companies theoretically cannot meet their debt service costs,” Khoda says. “And heading into one of the most profound interest rate cycles in the last 10 years, that’s a problem.”

Manager sources say they are concerned about the rise in B3-rated credits, but offer two key caveats. First is that the level of loan refinancings in 2021 has pushed back the maturity wall to a distance that puts it out of the recessionary period most analysts forecast. The second is that private equity sponsors are likely to put up additional equity to support companies through a recession in cases where capital structures are viable.

Khoda says that CLO demand has kept the prices of B3 credit inflated despite the risk rates pose to issuer viability.

“In an environment where the Fed has to go to a 4.5% total rate, B3s are going to see close to 25% of their free cash-flows evaporate, even without taking into account any margin pressure impact on free cash-flow,” she says. “That’s a challenge that’s not being taken into account in prices today, but B3s are CLO favourites, so that’s propping them up.”

Three-month US dollar Libor stands at 364 basis points as Creditflux goes to press. That’s up from 22bp at the start of 2022 and 163bp at the start of the third quarter.

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Global credit funds & CLO's

October 2022 | Issue 249

Published in London & New York.