More Junk-Rated Companies Are Facing Credit Downgrades and Defaults

The higher borrowing costs for risky credit are resulting in more rating downgrades and an acceleration of defaults. Default rates for low-rated U.S. companies will likely hit 5.4% in February 2024, up from 2.5% in February 2023 and higher than the long-term average of 4.7%, ratings firm

Moody’s Investors Service

said in a report last month. A recession as well as an increase in unemployment and wider credit spreads, or the difference in corporate bonds compared with that of safe Treasurys, could cause defaults to rise further, Moody’s said.

“What triggers a default is becoming more relevant in 2023, because everything is kind of worsening,” said Christina Padgett, head of the leveraged finance practice at Moody’s. 

Many defaults are expected to come from companies working through a distressed-debt exchange, a path for companies to lessen financial burdens and preserve cash by exchanging some debt. The exchange allows companies to reduce their debt load, but the reduction is often not enough to lead to positive free operating cash flow and frequently is followed by additional defaults, said Gregg Lemos-Stein, chief analytical officer for corporate ratings at S&P Global Ratings. 

Ratings firms classify companies pursuing a distressed-debt exchange as being at risk of a conventional default, with the intention of reviewing their financial prospects after the exchange and potentially raising the rating. “A distressed exchange is an attempt to avoid a formal restructuring process, but those attempts aren’t always going to be successful,” said Bradley Rogoff, head of fixed income, commodities and currency research at

Barclays

PLC, a U.K. banking group.

Speculative-grade-rated companies such as used-car retailer

Carvana Co.

and office-sharing firm

WeWork Inc.

were downgraded by at least two ratings firms in recent weeks while attempting a debt exchange. 

Ratings firm S&P Global Ratings on March 23 downgraded Carvana’s issuer credit rating by three notches, to CC, amid the retailer’s proposed offer to swap some of its outstanding senior unsecured debt into $1 billion of new second-lien secured debt, at a substantial discount to face value. Moody’s on March 29 dropped its corporate family rating—a type of long-term rating reflecting the likelihood of default—by three notches, to Ca, in part reflecting Carvana’s weak operating performance and negative free cash flow generation. 

Alan Hoffman, Carvana’s head of corporate affairs, said in a statement that the company is successfully executing on its operating plan and expects to continue making progress on its path to profitability. 

S&P on March 21 also downgraded WeWork’s issuer credit rating by three notches, to CC, after it reached a deal to cut its debt by roughly $1.5 billion and extend some maturities. Ratings firm Fitch Ratings on March 27 downgraded WeWork’s long-term issuer default rating by two notches, to C. The company’s sustained negative Ebitda, or earnings before interest, taxes, depreciation and amortization, and free cash flow are key limiting factors that restrict its operating and financial profile, Fitch said. WeWork declined to comment. 

For Carvana and WeWork, S&P said it expects to lower the rating to D, or default, if they complete their exchange offers, calling their capital structures unsustainable. 

Distressed-debt exchanges are usually a lever that companies pull to avoid filing for chapter 11 bankruptcy protection, which is particularly costly and generally forces equity and ownership to change hands. 

Companies approaching a default, for example those incapable of generating cash flow at the rate at which they would have to refinance, have limited options for avoiding a default-related credit rating. A distressed publicly traded company probably will have trouble issuing equity and would need to focus on slashing costs and demonstrating it can generate sustainable cash flow, potentially paving the way for a refinancing, Mr. Lemos-Stein said. 

S&P so far this year through the end of March has issued 85 U.S. corporate credit downgrades—for both high- and low-rated companies—up from 48 during the prior-year period. There were 41 S&P downgrades in March, the most in a single month since May 2020. The total number of downgrades in the first quarter exceeded that of upgrades, which stood at 55 at the end of March, down from 80 during the prior-year period. 

Meanwhile, U.S. leveraged-loan default volumes totaled $12.6 billion this year through March, up from $4.3 billion during the prior-year period, according to Fitch Ratings. Defaults totaled $26.6 billion in 2022, up from $9.7 billion a year earlier. 

The rise in defaults marks a normalization after a year and a half with almost no defaults, as companies’ efforts to preserve margins and profitability came at the expense of draining liquidity positions they strengthened in response to the pandemic, said Lotfi Karoui, the chief credit strategist at

Goldman Sachs Group Inc.

“I’ve been surprised by how fast companies have burned that massive amount of excess liquidity that they had built in 2020 and 2021,” Mr. Karoui said. 

Many companies haven’t yet faced the full impact of higher debt-servicing costs because they haven’t needed to refinance their debt, S&P’s Mr. Lemos-Stein said. About $696.5 billion in U.S. corporate debt is coming due in 2023 and roughly $982.7 billion due in 2024, 15% and 25% of which comprise speculative-grade debt respectively, according to S&P. 

“Some of the pain is still to come once those companies have to refinance and that’s why we see some companies waiting even into the final year,” he said.

Write to Mark Maurer at [email protected]

The higher borrowing costs for risky credit are resulting in more rating downgrades and an acceleration of defaults. Default rates for low-rated U.S. companies will likely hit 5.4% in February 2024, up from 2.5% in February 2023 and higher than the long-term average of 4.7%, ratings firm

Moody’s Investors Service

said in a report last month. A recession as well as an increase in unemployment and wider credit spreads, or the difference in corporate bonds compared with that of safe Treasurys, could cause defaults to rise further, Moody’s said.

“What triggers a default is becoming more relevant in 2023, because everything is kind of worsening,” said Christina Padgett, head of the leveraged finance practice at Moody’s. 

Many defaults are expected to come from companies working through a distressed-debt exchange, a path for companies to lessen financial burdens and preserve cash by exchanging some debt. The exchange allows companies to reduce their debt load, but the reduction is often not enough to lead to positive free operating cash flow and frequently is followed by additional defaults, said Gregg Lemos-Stein, chief analytical officer for corporate ratings at S&P Global Ratings. 

Ratings firms classify companies pursuing a distressed-debt exchange as being at risk of a conventional default, with the intention of reviewing their financial prospects after the exchange and potentially raising the rating. “A distressed exchange is an attempt to avoid a formal restructuring process, but those attempts aren’t always going to be successful,” said Bradley Rogoff, head of fixed income, commodities and currency research at

Barclays

PLC, a U.K. banking group.

Speculative-grade-rated companies such as used-car retailer

Carvana Co.

and office-sharing firm

WeWork Inc.

were downgraded by at least two ratings firms in recent weeks while attempting a debt exchange. 

Ratings firm S&P Global Ratings on March 23 downgraded Carvana’s issuer credit rating by three notches, to CC, amid the retailer’s proposed offer to swap some of its outstanding senior unsecured debt into $1 billion of new second-lien secured debt, at a substantial discount to face value. Moody’s on March 29 dropped its corporate family rating—a type of long-term rating reflecting the likelihood of default—by three notches, to Ca, in part reflecting Carvana’s weak operating performance and negative free cash flow generation. 

Alan Hoffman, Carvana’s head of corporate affairs, said in a statement that the company is successfully executing on its operating plan and expects to continue making progress on its path to profitability. 

S&P on March 21 also downgraded WeWork’s issuer credit rating by three notches, to CC, after it reached a deal to cut its debt by roughly $1.5 billion and extend some maturities. Ratings firm Fitch Ratings on March 27 downgraded WeWork’s long-term issuer default rating by two notches, to C. The company’s sustained negative Ebitda, or earnings before interest, taxes, depreciation and amortization, and free cash flow are key limiting factors that restrict its operating and financial profile, Fitch said. WeWork declined to comment. 

For Carvana and WeWork, S&P said it expects to lower the rating to D, or default, if they complete their exchange offers, calling their capital structures unsustainable. 

Distressed-debt exchanges are usually a lever that companies pull to avoid filing for chapter 11 bankruptcy protection, which is particularly costly and generally forces equity and ownership to change hands. 

Companies approaching a default, for example those incapable of generating cash flow at the rate at which they would have to refinance, have limited options for avoiding a default-related credit rating. A distressed publicly traded company probably will have trouble issuing equity and would need to focus on slashing costs and demonstrating it can generate sustainable cash flow, potentially paving the way for a refinancing, Mr. Lemos-Stein said. 

S&P so far this year through the end of March has issued 85 U.S. corporate credit downgrades—for both high- and low-rated companies—up from 48 during the prior-year period. There were 41 S&P downgrades in March, the most in a single month since May 2020. The total number of downgrades in the first quarter exceeded that of upgrades, which stood at 55 at the end of March, down from 80 during the prior-year period. 

Meanwhile, U.S. leveraged-loan default volumes totaled $12.6 billion this year through March, up from $4.3 billion during the prior-year period, according to Fitch Ratings. Defaults totaled $26.6 billion in 2022, up from $9.7 billion a year earlier. 

The rise in defaults marks a normalization after a year and a half with almost no defaults, as companies’ efforts to preserve margins and profitability came at the expense of draining liquidity positions they strengthened in response to the pandemic, said Lotfi Karoui, the chief credit strategist at

Goldman Sachs Group Inc.

“I’ve been surprised by how fast companies have burned that massive amount of excess liquidity that they had built in 2020 and 2021,” Mr. Karoui said. 

Many companies haven’t yet faced the full impact of higher debt-servicing costs because they haven’t needed to refinance their debt, S&P’s Mr. Lemos-Stein said. About $696.5 billion in U.S. corporate debt is coming due in 2023 and roughly $982.7 billion due in 2024, 15% and 25% of which comprise speculative-grade debt respectively, according to S&P. 

“Some of the pain is still to come once those companies have to refinance and that’s why we see some companies waiting even into the final year,” he said.

Write to Mark Maurer at [email protected]