Our outlook for U.S. corporate issuers remains cautious as we enter the second half of 2016. We believe leverage and other credit market risks remain high, with the U.K.'s referendum to leave the European Union (or "Brexit") only the latest source of uncertainty and vulnerability. While we think Brexit will have little direct impact on the corporate sector as a whole, "second-level" and spillover impacts--on the eurozone economy, capital market access, currency and oil markets, and confidence channels--could be more meaningful.
- Speculative-grade debt faces record leverage levels and liquidity risk.
- Brexit should have minimal impact on U.S. corporate issuers.
- Commodities face continued downward rating pressure from protracted low prices.
Don't Fight The Fed
Overall, the corporate sector's negative bias continues to increase, with stress still concentrated in energy and metals, given their pricing challenges. But given prevailing high levels of leverage, there are also significant downgrade risks in noncommodity sectors, particularly from mergers and acquisitions (M&A) in investment-grade debt and liquidity risk in speculative-grade debt. Still, uncertainty from Brexit has helped pare back further Federal Reserve rate hike expectations, which we think can go a long way in helping extend the late-stage U.S. corporate credit cycle.
But prolonged accommodative monetary policy is also not without its risks. In fact, S&P Global Ratings' research highlights that monetary policy easing in many countries has contributed to increased financial risk, with the growth of corporate borrowing outpacing global economic growth. An increasing proportion of companies are becoming highly leveraged, raising questions over their long-term debt sustainability, despite low interest rates supporting their ability to meet interest payments).
In addition, the search for yield spurred by easy monetary policy globally has fueled elevated asset prices that have some investors skittish. A series of major negative shocks could trigger a confidence crisis and extended financial market volatility. That could easily cause funding conditions to tighten sharply, posing a serious default risk for lower credit-quality companies.
As it is, we are expecting defaults to increase. We've seen a spike in defaults, particularly in the U.S. oil, gas, and mining industries, and there's likely more to come. S&P Global Fixed Income Research forecasts the U.S. trailing-12-month speculative-grade default rate will rise to 5.3% by March 2017 (with 104 defaults), up from 3.9% in April 2016. Defaults are expected to exceed the long-term average rate of 4.3% (since 1981) and are anticipated to be concentrated in the energy and commodity sectors (see chart 1).
Increased Leverage And Liquidity Risk In Speculative Grade
For investment-grade credits as a whole there has been little change in key credit metrics over the past decade. In fact, their interest coverage has improved, with many investment-grade companies opportunistically tapping the capital markets to refinance--with the net result being a reduction in interest costs. Given the favorable terms and extended maturity profile for outstanding debt obtained by investment-grade issuers after the financial crisis, we believe they are adequately insulated from potential capital market disruptions.
It's a different story for speculative-grade issuers. For this segment, leverage ratios are at a new high, while interest coverage has modestly deteriorated (see chart 2 and chart 3).
Although nonfinancial corporate debt is heavily investment-grade in terms of dollar value, speculative-grade debt has grown very rapidly in the past few years, which is weighing on the credit market's overall risk profile. And as of late, investors have found themselves in the unenviable position of scrambling to buy higher-yielding (or even just positive-yielding) assets, which includes extending maturities and buying speculative-grade corporate debt instruments. While negative interest rates is a relative new phenomenon, it further underscores the recent global thirst for yield. Thus, non-investment-grade borrowers have accounted for approximately 90% of the new issuers we have rated in the past three years (see chart 4). We now have speculative-grade ratings on 65% of nonfinancial corporate borrowers--up from 62% five years ago, 50% 15 years ago, and just 44% 20 years ago (see chart 5).
Our view is that a protracted period of volatile and scant liquidity in the primary market poses a greater risk to these lower-rated companies, especially those that need to access the credit markets to meet financial commitments. We've seen liquidity issues beginning to crop up at some 'B' and lower-rated credits, with several entering distress territory. And less receptive capital markets, as seen in late 2015 and earlier this year, amplifies this funding risk.
Brexit's Impact Is Minimal So Far
We don't expect Brexit to lead to rating changes for corporate issuers, but potentially drawn-out Brexit-related uncertainty is a headwind for U.S. economic growth and corporate sector performance. All in all, the size and diversity of the U.S. economy limits its exposure to the U.K., and the risks from trade and migrant flows, financial sector exposures, and foreign direct investment are very low (see "Who Has the Most to Lose from Brexit? Introducing the Brexit Sensitivity Index," June 9, 2016). U.S. exports and inward investment to the U.K. each represent only 1% of U.S. GDP.
U.S. corporations' direct revenue exposure to the U.K. is also very small. We estimate U.S. corporate issuers' revenues and EBITDA attributed to the U.K. are, on average, only about 1% and 0.5% of the total. However, the proportion of U.S. corporates' revenues and earnings emanating from the wider Western and Southern European region is much higher--in the mid-teens percentage. We forecast that eurozone growth will not be unscathed by Brexit, although the hit to GDP will be smaller than in the U.K.