US tariffs may create divergence in mid-market credit quality

Prolonged US tariffs could amplify the divergence in mid-market credit quality, Morningstar DBRS has warned.

In a new commentary note, Morningstar DBRS noted that tariffs on imported goods could drive at least a short-term increase in cost of raw materials and components to the end-user, posing challenges for lower-rated companies less able to pass costs on to their customers.

The firm believes that companies may be forced to absorb the increased costs, which could lead to deteriorating operating cash flows and weakened credit metrics.

Read more: Opportunity in US mid-market despite macro uncertainty

“If proposed US tariffs on Canada, Mexico, and Europe are fully implemented and remain effective for a prolonged time period, we believe this will have a net credit-negative impact, especially on the most leveraged middle-market borrowers,” said Candice Gao, assistant vice president of private corporate credit at Morningstar DBRS.

Morningstar’s analysis found that consumer products and merchandising issuers are likely to have a greater sensitivity to margin compression relative to industrials or services. This is due to a combination of lower relative margin compared with other sectors.

Read more: Credit investors must adapt portfolios for Trump tariffs

Over the past month, Morningstar DBRS analysts have observed an increase in the market’s perception of financial uncertainty, driven by mixed messages on US trade policy and rising geopolitical belligerence.

“Most of our rated issuers have sufficient cushion to absorb a moderate stress, such as a 100-basis point margin compression or a similar increase in borrowing costs,” said Michael Dimler, senior vice president, private credit, at Morningstar DBRS.

“However, we would expect to see significant downward migration in credit quality in the event of a more severe contraction in profitability and cash flow.”

Read more: Trump’s tariffs threat could hit private credit borrowers