(Bloomberg) -- The credit quality of smaller companies whose loans are packaged into collateralized loan obligations deteriorated through the second half of last year, the latest sign of the toll that higher interest rates are taking on a market that investors have poured money into.  

Between the second half of 2022 and 2023 Moody’s Ratings downgraded about one quarter of the loans bundled into securities known as middle market collateralized loan obligations, according to a report on Wednesday by the ratings company. Moody’s strengthened its estimates of credit quality on only around 5% of the loans over that period, leaving the rest unchanged, according to the report, which is based on CLOs the firm grades.

So far, the bonds that are backed by these loans haven’t experienced too much stress themselves, the report said. Even so, interest rates that remain elevated longer will likely pose a challenge, with more than one in five of the corporate borrowers potentially set to struggle to secure external financing when it comes time to refinance or raise new debt, Moody’s said in the report.

The report offers a window into a relatively opaque part of the credit market. Middle market firms – those with less than $200 million in earnings before interest, taxes, depreciation and amortization, generally – frequently don’t get official credit ratings when they raise funds. But when that debt is packaged up into CLOs, which do receive ratings, a rating company examines and assigns “credit estimates” to the underlying loans in order to understand the quality of the collateral.   

Middle market companies increasingly turned to private credit lenders after banks scaled back from financing them after the 2008 financial crisis. Lenders are increasingly bundling this debt into CLOs alongside larger direct loans, and there’s been a push among some issuers to rebrand middle market CLOs as private credit CLOs. 

In a recent review of its own credit estimates on loans in private credit CLOs, S&P Global Ratings said that in the third quarter of 2023 it downgraded more than four times as many estimates as it had raised. 

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