Moody's: Spec-grade first-time ratings surge in H1 2017, along with risk to investors

Low interest rates and high investor demand have triggered a surge in the number of spec-grade companies looking for a first-time rating. This reverses a three-year declining trend and heralds the return of more aggressive transactions that increase risk to investors, says Moody's Investors Service in a report published today.

"Active high-yield bond and leveraged loan markets, as well as issuer friendly conditions, have paved the way over the past 12 months for the current uptick in first-time spec-grade ratings. We expect this pace to continue as long as the overall market maintains its momentum. However, transactions are becoming more aggressive with higher initial leverage and weaker cash flow increasing risk to investors," says Tobias Wagner, Vice President at Moody's.

 

Moody's rated 52 new speculative-grade companies in the first half of 2017, or 88% of last year's full year total, indicating that the total for the current year will outpace 2016, reversing a trend since 2013.

Transactions are becoming more aggressive in 2017, with higher initial debt/EBITDA (Moody's-adjusted) and weaker cash flow generation, but improved macroeconomic conditions are keeping the average rating at B2. Some newly rated companies have a limited or weak operating track record, and some are highly exposed to business cycles, while others use optimistic adjustments to arrive at their EBITDA.

Companies first rated in H1 2017 at B1 and lower have the highest starting leverage since 2011. This trend could continue into H2, leading to riskier transactions seeking to access the high-yield bond or leveraged loan market. However, 21% of companies first rated in 2017 have ratings in the Ba range, which is the highest level since 2011. On average, though, these companies have higher leverage.

Spec-grade firms first rated in H1 2017 had the weakest average cash flow generation in the past five years. Their free cash flow to debt (Moody's-adjusted), which measures cash flow after investments, interest and dividends, is at less than 4%. Since lower cash flow is not the result of higher investment, companies first rated in 2017 expect generally weaker free cash flow than in previous years.

Companies first rated in 2017 will rely more on EBITDA growth to reduce leverage. On average, newly rated companies expect 6% revenue growth in the first year after rating assignment, which is in line with previous years' cohorts. While deleveraging expectations remain in line with previous years, those first rated in 2017 will rely more on EBITDA growth and managements' ability to achieve expectations, given lower cash flow.

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