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By Matt Tracy
WASHINGTON (Reuters) – The credit quality of U.S. middle market collateralized loan obligations (CLOs), major sources of debt funding for mid-sized companies, has worsened only slightly even as the overall risk of late payments by these companies has increased, according to Moody’s (NYSE:MCO).
The new data suggests that despite increasingly challenging liquidity conditions and rising interest rates, demand for mid-sized companies’ debt has persisted, in contrast to fears funding would dry up as the Federal Reserve combats inflation with higher interest rates.
CLOs are pools of leveraged loans, structured as one actively managed security. They have become the biggest source of funding for non-investment grade companies seeking debt financing.
According to the Moody’s report, mid-sized borrowers’ cash flow relative to their debt has deteriorated significantly since last year, as have their prospects for refinancing debt maturing in 2024.
The percentage of mid-market borrowers with “weak liquidity” – or those that depend on external, and highly uncertain, financing options – grew from 7% in the first quarter of 2022 to roughly 30% in the first quarter of this year, the report said.
Nevertheless, the mid-market CLOs’ own credit profiles “have worsened only slightly.” Loans to mid-sized borrowers maturing in 2024 made up just under 9% of the CLO books examined by Moody’s, due in part to the rolling nature of Moody’s credit estimates.
CLO managers have also actively assessed the loans in their tranches for potential loans that pose the greatest risk of default, switching them out for safer loans as needed.
Shiloh Bates, partner and chief investment officer at alternative credit manager Flat Rock Global, pointed to the performance of mid-market loans post-pandemic.
“During the last two years, middle market loans have shown their resiliency, though interest coverage ratios have retreated from record highs,” Bates said.