Storm clouds gather over highly indebted companies, Moody's says

Credit ratings agency Moody's Investors Service Inc said on Wednesday it has pushed more highly indebted companies to the bottom of its junk ratings barrel and that debt defaults are also on the rise as financing conditions tighten.

The number of companies rated B3 negative or lower by Moody's rose to 227 in the first quarter of 2023, a 4% increase from the fourth quarter of 2022 and a full third more than the first quarter of 2022, according to two reports from the agency.

That is the highest quarterly figure since August 2021 but still below a pandemic-era peak. The list includes movie theater chain AMC Entertainment Holdings AMC.N, textbook publisher Houghton Mifflin Harcourt and drugstore chain Rite Aid RAD.N.

Moody's cited elevated debt, weak profitability and price pressure among the reasons for the downgrades.

"We expect the (list) to continue to grow in size, given difficult credit conditions and market volatility...," analysts wrote in one of the two reports.

Much of Moody's rating actions are driven by the Federal Reserve hiking interest rates to combat inflation. This raises the financing costs for companies, especially those that use a lot of debt such as the ones owned by private equity firms.

Private equity-owned companies make up nearly three-quarters of Moody's list.

"The rise in interest rates materially increased the debt-service costs on some of these companies' floating-rate debt, resulting in weaker interest coverage," the Moody's analysts wrote.

In addition to higher interest payments, Moody's noted, many of the downgraded companies have fewer funding paths to staying afloat. This is because many lenders have retrenched after last month's banking crisis.

Over the next year, Moody's expects corporate defaults to more than double to 5.6% from 2.7% currently.

Sixteen of the 30 companies that fell off Moody's at-risk list last quarter did so through defaults, not improved financial outlooks.

More than half of last quarter's 16 defaulted companies avoided bankruptcy through distressed exchanges, using loose covenants in credit agreements to restructure debt.

As defaults rise, distressed debt exchanges will be the route of choice for many companies and their private equity owners, Moody's noted.

"Over the next 12 months, the number of distressed exchanges (DE) will continue to climb, given that an overwhelming majority of the lower-rated spec-grade debt issuers are private-equity (PE) owned companies," the analysts wrote.

Of the other companies that fell off Moody's list last quarter, seven opted instead to file for bankruptcy. These include regional sports channel operator Diamond Sports Group and retail chain Party City PRTYQ.PK.