This article is written and published by S&P Global Market Intelligence; a division independent from S&P Global Ratings. S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence PD credit model scores from the credit ratings issued by S&P Global Ratings.
U.S. corporate bankruptcy filings with over $1 billion in liabilities reached a seven-year low in 2021, and the market saw record-setting M&A levels, making for a rosy and optimistic 2022 outlook. However, since early February, markets have become much more volatile. Inflation and interest rates have risen, and many other global factors, such as the Russia-Ukraine conflict, the pandemic, supply chain issues, and labor shortages remain tenuous. To address these issues, S&P Global Market Intelligence hosted a webinar on June 23rd with an expert panel to discuss the bankruptcy outlook. This blog summarizes some of the highlights of the discussion.
Panelists
Charlsy Panzino (Moderator), Reporter, Credit and Markets, S&P Global Market Intelligence
Akshay Chothani, Senior Analyst, Quantitative Modeling, Credit & Risk Solutions, S&P Global Market Intelligence
Aaron L. Hammer Partner, HMB Legal Counsel
Robert M. Hirsh, Partner, Bankruptcy and Restructuring Department, Lowenstein Sandler LLP
Scott V. Stuart, Chief Executive Officer, Turnaround Management Association
Session Highlights:
The current environment. Business Chapter 11 filings are up, but it is not significant enough to predict a trend at this point. Also in the $100 million-plus asset category of public filings, the volatility remains relatively low, and the story is the same with leveraged loan default rates. The distressed debt warning, however, is definitely up. In the U.S. and around the world, stimulus money and related tax credits shut down restructurings in 2020, and there was an expected deferral. Issues of money mismanagement and fraud started to bubble to the surface, and there was an expectation that the shield of the zombie companies would be lifted once the stimulus ran out. What no one saw were the sustained supply chain and underemployment issues, along with a continuum of rising inflation and interest rates that are putting a strain on traditional lending. In addition, the war in Ukraine has thrown the energy sector and the environment of geopolitical stability into the abyss.
The U.S. economy is going to tip into a recession next year according to 70% of leading economists that have been polled by the Financial Times (FT). The tension between using interest rate hikes to break the highest inflation rates in 40 years will continue at a pace not seen in decades. There is a concern that bringing incomes and spending down just enough to bring prices back to the Fed's 2% target is not realistic. Those polled by FT and Booth believe that core inflation will stay above 3% or higher by the time we get to the end of 2023. So, the stage is set for far more volatility in sectors such as retail, commercial real estate, manufacturing, and automotive, to name a few. The uncertainty brought about by the many unforeseen stresses of the last half year puts the road ahead in very rocky shape.
Quantitative credit risk assessments. Quantitative models that generate probabilities of default (PDs) and credit scores can reveal a lot about potential bankruptcies. S&P Global Market Intelligence’s Probability of Default Market Signals (PDMS) model combines equity market data − such as market volatility, share price, and market cap − to arrive at a point-in-time estimate of credit risk by generating both a PD value and a credit score.[1] Since the model doesn’t need to wait for quarterly financial statements to be released, it provides very useful early warning signals for the financial deterioration in a company or portfolio to help with active credit risk monitoring. For example, PDMS showed that airline, hotel & gaming, media, and energy companies would be highly impacted during the COVID-19 pandemic. While we might have thought that healthcare would benefit in a pandemic environment, PDMS warned of an increase in the default risk for this sector, as well. This was because healthcare infrastructure was not prepared for such an onslaught of COVID-19 cases, plus the need for more equipment, products, and staff time led to increased costs for hospitals. Today, continued supply chain issues and the Russia-Ukraine war are increasing costs and raising PDs across numerous industries. As shown in Figure 1, during the five-month period from December 2021 to May 2022, we saw more downward changes in credit scores across industries.
Figure 1: Changes in Credit Scores from December 2021 to May 2022
Source: S&P Global Market Intelligence. As of June 1, 2022. For illustrative purposes only.
Note: S&P Global Ratings does not contribute or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiation PD and credit model scores from the credit ratings issued by S&P Global Ratings.
Scenario analysis can also be very helpful to assess potential bankruptcies under different outlooks for the future. S&P Global Market Intelligence’s Macro-Scenario Model is a global model with country differentiation and is used for this ‘what if’ analysis. Three scenarios have been created that capture different possible trajectories given the current instability in the macro environment. In the baseline scenario, there is a high increase in the PD value for airlines and automotive, mainly due to the global nature of these industries, as well as the impact of high oil prices. In the downside scenario, even higher oil prices and rising interest rates place extra pressure on airlines and automotive, as well as on the telecom industry. It is clear that the impact of slow growth, high interest rates, and increasing inflation will vary across industries, requiring detailed industry-specific analysis to fully understand potential bankruptcies.
Figure 2: Credit Risk Projections from the Macro-Scenario Model
Source: S&P Global Market Intelligence. As of June 1, 2022. For illustrative purposes only.
Additional insights on vulnerable industries. 2022 insolvencies are expected to be slow, and a historic low for bankruptcy cases.
Airlines: Losses in the airline industry will likely total $9.7 billion, according to the International Air Transport Association. It is an improvement on the $11.6 billion deficit that was predicted at the group’s previous gathering. Rosier times are returning. American Airlines Group’s first-quarter revenue was $8.9 billion, representing an 84% recovery from the comparable period in 2019. Other airlines look better, as well.
Home builders. In April 2022, the National Association of Home Builders warned that rising mortgage rates due to the Fed's tightening monetary policy would aggravate housing affordability challenges in 2022. Building material costs are up 19% from a year ago, and mortgage rates have surged to a 12-year high. In addition, based on current affordability conditions, less than 50% of new and existing home sales are affordable for a typical family. The U.S. Department of Housing and Urban Development and the U.S. Census Bureau both reported overall housing starts falling by 14.4% to a seasonally adjusted annual rate of 1.55 million units in May.
Retail. Can anything save retail from Amazon or discretionary consumer spending getting hit because of rising interest rates and inflation? Notably, retailers experiencing stress and default risks are taking action in advance of a full-scale financial restructuring. For example, CVS plans to close 300 stores per year between 2022 and 2024 as part of a shift to e-commerce. Many others are doing the same.
Cryptocurrency exchanges. With the combination of rising interest rates causing investors to move money to safer bets, the invasion of Ukraine causing inflation and supply chain issues, and stablecoin TerraUSD collapsing, crypto exchanges are struggling to keep up. Mass layoffs have occurred across the industry to offset declining revenues. Celsius cited extreme market conditions. In a bankruptcy proceeding, absent regulation, courts are unlikely to recognize owners of cryptocurrency who might not get deposits back because they are unsecured creditors. The future of crypto is not entirely grim, as many companies are holding their money in stablecoins, which are secured with U.S. dollars or comparable obligations.
The Fed's latest activities. What is going to happen when the Fed continues to increase rates, and how is that going to impact various sectors of the economy? The current Federal Fund Rate is around 1.5% to 1.75%. Clearly, as interest rates increase, liquidity will eventually dry up, which will have a direct impact on the bond market. It is unclear how high rate hikes need to be to have a significant impact on credit defaults or corporate defaults, as it is uncharted territory. It is a foregone conclusion that the Fed will have to use rate hikes to combat the current runaway inflation. Unless such rate hikes are extremely high, it is doubtful that they will be a direct contributor to corporate bankruptcies. So, how much will the Fed raise interest rates this year? Based on everything that is out in the market, rates will probably be raised at least another 2.5% this year. The bulk of market participants were betting that Fed officials could push their key benchmark rates all the way up to 2.75% to 3%, which would be the most tightening in a single year since the 1980s. It could even go higher.
The recent rapid increase in at-risk credits (ARCs) is definitely one indicator of future default activity. ARCs are U.S. trace-traded bonds that are not in default, with prices that generate yields of more than 10%. ARCs are a relatively observable indicator of distress in the marketplace, so the number count and the dollar amount are the tip of the iceberg of financial distress. ARCs have doubled just in the last month, increasing from $69 billion to $139 million. It is unknown what the Fed will actually do, but it is highly likely that interest rates will continue to increase, the bond market will feel it, liquidity will dry up and there will be an avalanche of restructuring activity across most, if not all, sectors.
To find out more about the PDMS and Macro-Scenario models used to perform this credit risk analysis, please request a demo here >
[1] S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence credit model scores from the credit ratings issued by S&P Global Ratings.