Morningstar DBRS flags worsening private credit quality as downgrades increase

By Tatiana Bautzer

NEW YORK, Feb ‌23 (Reuters) - Quality in ​private credit ​has continued to worsen this year, according to rating agency Morningstar DBRS, as the proportion of downgrades reached a new high in February.

The number of downgrades ‌was 3.3 times the upgrades this month, up from 2.4 times a ⁠year ago. The outlook for 2026 remains negative, considering margin compression in different sectors and rising debt levels, ‌said Michael Dimler, senior vice president ‌for private credit ratings, in an interview on Monday.

Morningstar DBRS provides private credit ratings for around 450 middle market borrowers throughout North America and Europe, with an average revenue ​of $250 million.

As private credit volumes grow, markets are trying to assess default and liquidity risk to lenders, including large private equity firms. Private credit lenders do not usually disclose data ⁠that allows investors to understand where the main problems could happen. On the other hand, loans in public markets or ​bank balance sheets are easier to analyze and disclose more information about potential defaults and risk.

As downgrades increase, the average quality of the portfolio ​of companies rated by Morningstar DBRS worsened. The percentage ‌of companies seen as safer credits, with higher ratings such as B, fell from 41% to 39% over the last 12 months.

Riskier companies, ⁠classified between the ratings CCC and C, now represent 16% of the total, up from 12% a year ago. Defaults have also been rising, reaching 4% in February, above 3.2% in the prior year.

AI ⁠DISRUPTION

Morningstar DBRS is attentive to the disruption risk to software companies by artificial intelligence use, but so far ​the effect on the ratings has not been so big among the companies rated, Dimler said, comparing the current changes to the transition a decade ago from physical distribution of software to cloud and subscription-based ‌sales.

"Software developers' results were affected for some years, but companies that invested were able to complete the transition and improve earnings later", he ‌added.

Borrowing costs are already rising and some software companies are opting to delay debt deals, Reuters reported ⁠on Monday.

As analysts look for companies ‌that could be most affected, ​the main criteria are the customer relationships and how costly it is for clients to switch the software, according to Dimler.

(Reporting by Tatiana Bautzer; Editing by ‌Aurora Ellis)

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