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Junk-rated companies face greater downgrade risks if the economy slows

High-yield companies in the consumer goods, healthcare and entertainment industries are increasingly at risk of credit downgrades and even defaults as they grapple with rising interest rates and falling earnings, forcing some CFOs to consider alternative financing options.

Default rates for low-rated U.S. corporates are projected to reach 3.75% in the 12 months to September 2023, up from 1.6% in September 2022, but below the long-term average of 4.1% and default rate of 6.3 % as of September 2020, rating firm S&P Global Ratings said in a report earlier this week.

This expected doubling of default rates puts a spotlight on speculatively valued companies like drugstore chain Rite Aid Corp.,

Home Goods Retailers Bed Bath & Beyond inc

and Herbalife Nutrition GmbH.

, which makes protein shakes and dietary supplements. Each of these companies has been downgraded by at least one rating agency in recent weeks.

Although it’s unclear whether the downgrades will result in defaults, the rating agencies’ warnings come at a dangerous time. The Federal Reserve has hiked interest rates to levels not seen in over a decade, taking the benchmark interest rate to 3.75% to 4.00% earlier this month. At the same time, the economy has lost momentum, resulting in lower earnings and a clouded outlook for companies, particularly in consumer-facing sectors.

The recent surge in companies rated minus B — or six notches below investment grade — could contribute to more deterioration in corporate credit ratings if inflation and debt service costs remain high or rise further and supply chain problems persist, S&P said. Credit downgrades can drive up funding costs for companies and prompt executives to take additional measures, such as: B. reducing the debt burden.

Troubled companies should consider options to restructure their balance sheets, perhaps by selling equity, divesting minority interests or cutting costs, said Don McCree, vice chairman and head of commercial banking at Citizens Financial Group inc,

a bench. “If your rating is trending down, that probably indicates credit deterioration at its core,” he said.

Fitch Ratings on Nov. 9 downgraded Rite Aid’s long-term default rating from B to C — down three notches — after a proposed $385 million bond offering that Fitch described as a distressed exchange. The Philadelphia-based company announced last month that it was facing higher costs related to its store-closing plan and warned of increasing pressure on consumer spending and its supply chain for the remainder of the year.

Union, NJ-based Bed Bath & Beyond said in September it was considering liability management transactions — which typically allow companies to refinance or restructure outstanding debt — attached to $284 million in bonds due in 2024. Rating agency Moody’s Investors Service last month downgraded the company’s rating from Caa2 to Ca, down two notches, citing a “very high probability” of default over the next 12 months. S&P downgraded the company to selective default on Nov. 14 because of a distressed stock exchange from CC, the offer that Bed Bath & Beyond extended two days later.

Rite Aid and Bed Bath & Beyond did not immediately respond to requests for comment.

Companies that are six to eight notches below investment grade need to be cash flow positive, in part because they may need to refinance, said Gregg Lemos-Stein, chief analytical officer for corporate ratings at S&P Global Ratings. Leaders should “be able to close the hatches and show that you can fund yourself during this difficult time,” Lemos-Stein said.

S&P has issued 215 US corporate loan downgrades this year through the end of October — for both highly and low-rated companies — up from 158 in the same period last year, but down from 759 in 2020, when Covid-19 weighed on corporate earnings. There were 33 S&P downgrades in September, the most in a single month since June 2020. However, the total number of downgrades remained smaller than that of upgrades, which stood at 233 at the end of October versus 361 in the same period last year.

Junk-rated companies have been scrambling for the right time to attract investors in recent months, with some agreeing to pay more on their debt and others renegotiating with lenders or seeking additional financing in the personal loan market. “The impact of rising interest rates on low-rated companies, which are largely funded through the floating rate market, will be difficult for many companies to absorb,” said Christina Padgett, head of leveraged finance practice at Moody’s.

US companies are downgraded in part because of deteriorating cash flow and profitability levels, although circumstances are often company-specific, Mr McCree said. Credit conditions, particularly for sub-investment grade companies, are likely to tighten further as the Federal Reserve tightens monetary policy further. How badly companies will suffer depends on the depth and duration of a possible recession, rating experts said.

However, companies with no immediate need for refinancing tend to see less of a direct impact from credit downgrades. S&P last week downgraded Herbalife, the Los Angeles-based nutritional company, from BB- to B+ after reporting a 9.5% decline in revenue to $1.3 billion and a 30% fall in net income. to $82.2 million, both compared to the same period last year. According to S&P, high inflation reduced consumer demand for Herbalife products.

But the downgrade has minimal financial impact on Herbalife because the interest rate on its current debt is not rating-dependent and it will not need refinancing for years to come, Chief Financial Officer Alex Amezquita said. The company has about $550 million in convertible debentures due 2024 that it plans to repay on a revolving credit facility, he said.

“Obviously the company would prefer S&P not to downgrade, but we understand why S&P cited macroeconomic conditions as the catalyst for the downgrade,” said Mr. Amezquita.

Write to Mark Maurer at [email protected]

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