About That Next Shoe.

Starting the year with two failures from investment grade is a sobering reminder of current financial market volatility.??Our ratings always embed the expectation that ratings at any level in the scale can default (or, in the case of bank Viability Ratings, fail) – but clearly failures need to be much fewer in number for higher ratings than for lower ratings.

Bank failures from all investment-grade VRs between 2012-22 were in fact just 0.06% of rated issuers.?Admittedly a low number, but any non-zero result helps underline the speed with which evaporating confidence can overwhelm even lower investment grade fundamentals.??

The background to the U.S. bank turmoil included topics we had previously highlighted when revising the Sector Outlook for US banks to Deteriorating last November, and again when flagging in some detail the risks of deposit competition and unrealized bond losses in January.

When 5G is Not Your Friend

Confidence can be a fragile element.??Channels for knock-on effects are now much more visible, and can move at infinitely faster speeds than in years past.?But policy action and a measured response from market observers has avoided further contagion so far.?In fact, as a measure of contagion, even with the additional related downgrades of Pacific Western Bank and Western Alliance Bank in the U.S., our global financial institution portfolio still ended 1Q23 with net upgrades.??

As we have said many times before, the global economy nonetheless remains in a febrile state.??Profits may well be tougher for banks in coming quarters - we believe interest rates have probably passed the optimal point between helping and hindering bank profitability.??Future developments at First Republic Bank will be closely monitored for their impact on market sentiment. Are there other areas where credit pressure could return??Where is the next metaphorical shoe likely to fall?

Some common candidates we can exclude.??We expect a fairly benign environment for commodities for example. But it still pays not to hunt too far beyond the obvious for the next shoe.?Two recurring headliners are worth exploring.??

Are Offices the New B-malls?

We flagged last November the particular nexus of refinancing and cloudy fundamentals for U.S. commercial real estate.?With loans from the post-GFC vintage CMBS transactions heading into refinancing, and with CRE loan market rates a good 200bps above current loan rates, we estimated a significant hike in delinquencies for 2023, with some fairly precise sector-specific refinancing success rate assumptions.??

? Interactive Chart

Fast forward to March 2023, and 60+ day delinquencies sit at a comforting 1.8% currently, but we still forecast a rise to 4-4.5% by year end, as the refinancing burden for CMBS 2.0 gets into full swing.

The core debate revolves in many ways around a simple question: are offices the new B-malls??We expect permanent valuation impairment for weaker assets as the market reprices the office sector, similar to B-malls, with secularly slower cash flow growth and higher obsolescence risk, including for some Class A office properties. The pandemic accelerated and expanded the secular shift to lower tenant space demand.

Market signals are fairly clear – share price performance for US office REITs (trading at a median discount to NAV of more than 40%) suggests an implied 200bps hike in cap rates for the sector, compared to optically stable cap rates per ACLI.?The shift in CMBS loan underwriting standards we had already identified between 2013 and 2014 (with lower DSCRs and higher LTVs) will pose an additional hurdle across the sector going into next year.

Of some comfort, when we looked at the deeper drivers, they show a more nuanced mix – the office market is more fragmented and arguably more liquid versus malls, but the segment faces far lower barriers to entry; offices face more demanding green transition costs than malls, but have better alternative use prospects.

Exposures for investors will vary. The directly rated portion - CMBS transactions - are also arguably amongst the most insulated of CRE exposures – we add on a 200bp cushion in our surveillance process, and a vibrant ecosystem of servicer advancing helps cover time spent in either refinancing or liquidating properties.

But commercial real estate also forms a substantial element of the balance sheets of (particularly smaller) U.S. regional and local banks - we estimate that CRE loans accounts for more than 30% of total assets for banks with $1-10bn in assets, compared to just 6% for banks with assets over $250bn.

The Other B-category

Similarly, leveraged corporate loans – our largest single portfolio of low speculative grade ratings – continue to post benign trailing default rates of 2.0% in the US and 1.2% in Europe.??But these portfolios are located at the foot of the rating scale for a reason.

We ran detailed stress tests through both the US and European LF portfolios, that superimposed a sudden repricing to current interest rates.??The impact on the share of entities covering both interest and maintenance capex was stark, if entirely consistent with their very low ratings.??The analyses underlined both portfolios vulnerability to defaults, with a quarter of all ‘B’ category leveraged loans in the US and almost 40% in Europe falling below 1x coverage of interest and basic capex if refinanced at today’s market lending rates.?We also added a stress for lower EBITDA – our global corporate forecasts have indeed dimmed alongside everyone else’s – which increased the coverage fails further. Figures are similar for our APAC HY portfolio.

I would emphasize both that this is an artificial stress – almost half of ‘B’ category leveraged debt in Europe is fixed, for example, though this is much lower for 'B-' names – and that the largest publicly-rated product using these ratings – the CLO portfolio – typically has a strong track record of avoiding the weakest names.

But the pace at which things take a turn for the worst has been a theme so far this year.??Our ratings talk to relative vulnerabilities, not relative certainties - due caution remains advised.

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