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Fitch projects rising junk-debt downgrades for 2020

Fitch Ratings expects the U.S. institutional leveraged loan default rate to climb to 3% in 2020 from the current 1.8% rate, based on the growing number of loans of concern from increasingly stressed corporate borrowers.

However, the agency still believes “economic fundamentals and market access remain modestly constructive for leveraged U.S. corporates," according to a Fitch analyst.

"Growing outstanding amounts on our [loans] of [c]oncern, net downgrade pressure and increased investor skepticism toward lower-rated and aggressive sponsor deals defined second-half 2019," said Michael Paladino, managing director and head of U.S. leveraged finance, according to a release. "These themes are likely to shape 2020 trends.”

Fitch’s list of loans with growing risks of downgrades reached $110 billion in December, up 53% year-to-date. “The increase reflects our view that pockets of the market are likely to face headwinds next year,” the report stated. (Loans falling into the area of "concern" involve varying components of low ratings, discounted secondary market levels, adverse market information or events.)

Also this year, the number of Fitch downgrades outnumbered the number of upgrades by the widest margin in a decade.

The universe of the lowest-rated triple-C loans (4.8% of outstanding first-lien institutional loans) is actually down from 2017 (5.9%), but the percentage of loans that Fitch rates at B- has “ballooned” to 15% from 9% in the same period. (Those lower-rated single-B loans are just a notch above the triple-C category.)

Leveraged-loan issuance has totaled approximately $350 billion in 2020, “well behind” the pace of the $712 billion volume in 2018 – which was the tail end of a two-year surge of high repricing and refinancing activity by a market that was expecting a prolonged rate-hike cycle.

The market was heavily fueled by LBO activity, with buyout fundraising surpassing $250 billion in the first three quarters of 2019 to outpace every full year since 2007, the report stated.

Fitch pointed to ongoing weakness and the lack of market access for the lowest-rated firms in the energy sector, which has led to a 13% default rate on energy loans (as well as 7% for high-yield bonds). Retail remains a concern as well, “while lower-rated pockets of healthcare/pharmaceuticals and technology present growing risks,” according to a Fitch release.

The shift toward more lower-rated firms in the speculative-grade space has been spurred by “highly levered capital structures” when loans are issued, and reliance on “aggressive” earnings assumptions – an observation echoed from recent comments by Alan Waxman of TPG Sixth Street Partners.

“Investors are showing a notable preference for 'BB' rated loans over 'B' and lower issues, as sponsored transactions generate more push-back and CLO managers seek to limit potential exposure to 'CCC' credits in the event of further downgrades, creating pressure on secondary market trading levels,” Fitch’s report also noted.

The pressure has grown on junk-rated companies that have had increased leveraged and weakened ratings after years of “robust” loan demand that fueled debt-funded merger and acquisition activity, leveraged buyouts and dividend recapitalizations. But “[l]ower interest rates have reduced demand for floating rate loans, but are broadly supportive to the speculative-grade credit market. U.S. debt is likely to remain attractive on a relative basis, absent an economic shock,” according to Fitch.

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