Financial market stress, mixed economic signals, and a very unpredictable political backdrop globally have led the Fed and European Central Bank to pause on further rate hikes and extend their various quantitative easing (QE) initiatives. This should help keep corporate borrowing costs stable, taking some pressure off the default rate. That said, markets appear to still be cognizant of risk--speculative-grade borrowing costs have been more volatile over the last six months, particularly for lower-rated issuers.
Amid these conditions, S&P Global Fixed Income Research expects the U.S. trailing-12-month speculative-grade corporate default rate to increase to 2.7% by March 2020 from 2.1% as of March 2019 (see chart 1). However, this is down from 3.2% in March 2018 and is lower than our default rate forecast of 3.1% for December 2019.
In our pessimistic scenario, we forecast the default rate will rise to 4%. In this scenario, we assume further deterioration in the U.S.-China trade situation, resulting in the U.S. expanding the list of Chinese goods subject to 25% tariffs, as well as stronger actions against intellectual property violations, all resulting in decreased trade and financial market volatility. We also assume a more prolonged period of an inverted yield curve, which could prompt even more financial market selloffs ahead of a feared recession over the following 18-24 months.
In our optimistic scenario, we forecast the default rate will fall to 2.2%. We assume an improved trade situation between the U.S. and China, with U.S. tariffs on Chinese imports falling back to 10% and being limited to the current list of goods totaling $200 billion. A key factor in our optimistic scenario is the possibility that the Federal Reserve cuts interest rates later in the year, as many market participants already believe.
Even in our optimistic scenario, we assume corporate earnings growth will not perform as robustly as it did after the 2017 tax cuts, and economic growth will still slow relative to 2018. Still, a lower floor on borrowing costs that should result from Fed rate cuts would provide some room for corporate borrowers to manage their maturity profile over the next 12-18 months.
The Energy And Consumer Sectors Are Likely To Lead Near-Term Defaults
As lending conditions have been favorable over the last 10 years, defaults have remained muted across most sectors outside of energy and natural resources, which saw a spike in 2016, largely as a consequence of dramatically falling oil prices. More recently, defaults have become more frequent among the consumer services sector, which includes consumer products and retail/restaurants. These sectors have been facing difficulties as consumers are shifting more of their purchases online, and increased price discovery has squeezed margins in recent years.
Although the default rate is at its lowest point in almost four years--amid a strong U.S. economy, still relatively low bond spreads, and an extra boost from recent tax reform--we still expect the energy and natural resources and consumer services sectors to remain at the forefront of defaults over the next 12 months. Together, they account for 46% of all U.S. firms currently rated 'CCC+' or lower by S&P Global Ratings. Retail sales are still growing steadily, but at a slower pace relative to mid-2018, while consumer confidence remains near a multiyear high. Meanwhile, oil prices have risen roughly 38% since their low at the end of 2018, to $62.3 on May 6 from $45.15 at the end of 2018, though prices have been volatile.
In early 2015, both the number and percentage of defaults in the energy and natural resources sector began increasing significantly, and the industry has been the primary contributor to the overall default rate in recent years, particularly in 2016 (see chart 2). There has been little spillover to other sectors, however. Since the start of 2017, the sector's default tally has been declining, bringing the overall default rate back in line with the default rate excluding energy and natural resources.
The consumer services sector's proportion of defaults has increased since mid-2017. The sector's ratings distribution leans heavily speculative grade (75%), and many companies have high debt loads that could pose challenges as they approach maturity and structural shifts progress. Although the sector has seen a marked decline in its net downgrade rate (upgrades minus downgrades) since 2017, it has had a slight increase in net downgrades since the beginning of the year, as has the overall speculative-grade segment (see chart 3).
Meanwhile, the leisure and media sector and the telecommunications sector have experienced increased speculative-grade downgrades since the first quarter of 2018. These two sectors and consumer services account for just under one-third of speculative-grade issuers in total. And though telecommunications is currently leading in terms of net downgrades--with 8.3% through March--it is a relatively small sector, contributing only 3.51% to the speculative-grade total.
Bond And Loan Dynamics Have Shifted After Fed Statements
High-yield bond and leveraged loan issuance contracted noticeably in the fourth quarter of last year, but issuance has, as expected, rebounded since. Some of this is a likely correction after the poor fourth-quarter totals, but even so, total speculative-grade issuance is off slightly relative to last year. Through March, speculative-grade bond issuance has reached $58.2 billion, up from $53.6 billion at the same point last year (see chart 4).
Meanwhile, leveraged loan issuance totaled $134 billion, compared with $170.1 billion over the same period. Bond issuance increased slightly, while leveraged loans have fallen back, largely a result of the Fed pausing its rate hike trajectory (see chart 5).
We expect speculative-grade bond issuance in 2019 to also be down somewhat, though far from the 40% decline last year. Despite such a low total and expectations for continued headwinds in 2019, the maturing debt total of $124.6 billion over the 12 months ending April 30, 2020, is below the $146.8 billion of new bond issuance in the 12 months through March 31, 2019. Still, the ratio of upcoming maturities to the trailing-12-month bond issuance total is now much higher than in recent years.
How We Determine Our U.S. Default Rate Forecast
Our U.S. default rate forecast is based on current observations and on expectations of the likely path of the U.S. economy and financial markets. In addition to our baseline projection, we forecast the default rate in optimistic and pessimistic scenarios. We expect the default rate to finish at 2.2% in March 2020 (42 defaults in the trailing 12 months) in our optimistic scenario and 4% (76 defaults in the trailing 12 months) in our pessimistic scenario.
We determine our forecast based on a variety of factors, including our proprietary default model for the U.S. speculative-grade corporate bond market. The main components of the model are economic variables (the unemployment rate, for example), financial variables (such as corporate profits), the Fed's Senior Loan Officer Opinion Survey on Bank Lending Practices, the interest burden, the slope of the yield curve, and credit-related variables (such as negative bias, defined as the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications).
In addition to our quantitative frameworks, we consider current market conditions and expectations. Areas of focus can include equity and bond pricing trends and expectations, overall financing conditions, the current ratings mix, refunding needs, and both negative and positive developments within industrial sectors. We update our outlook for the U.S. speculative-grade corporate default rate each quarter after analyzing the latest economic data and expectations.
Default And Credit Market Stress Signposts
After a rough start to the year, economic and financial conditions have improved after the Fed announced it would not raise interest rates this year. Nonetheless, there are risks to the default outlook, despite many fundamentals being currently strong. Economic growth is expected to slow this year, with our economists forecasting GDP growth of 2.2% in 2019 and only 1.7% in 2020. Fiscal stimulus will fade, and the honeymoon period for companies following corporate tax reform is over.
Aftertax corporate profits increased 14.3% on a year-over-year basis in the fourth quarter, finishing the first year under the new tax code with sizable gains (see table). We anticipate profits to be roughly flat in the first quarter now that annual comparisons will no longer benefit from a reduced tax rate for corporations. Thus far, about 90% of the S&P 500 constituents have reported first-quarter earnings, which, in total are showing about a 1.5% increase from last year. That said, sectors more heavily represented in the speculative-grade segment (communication services, energy, materials) have thus far reported very large declines, of over 20%.
The yield curve---which we define as the difference between the 10-year and three-month Treasury yields--has been steadily falling since the end of 2013 and has temporarily inverted recently. At the end of the first quarter, it was only 1 basis point, and it fell back into negative territory on May 13. Historically, an inverted yield curve has been considered a warning signal of a possible recession, with a lead time of about 18-24 months. An inversion has also preceded the last three times the default rate hit double digits.
Market volatility ebbed in the first quarter, with the VIX finishing March at 13.7, from 25.4 at the end of 2018. Speculative-grade spreads followed suit, falling to 385 basis points (bps) by March 31, from 482 on Dec. 31. That said, markets have recently turned uneasy again after the negative developments in the ongoing U.S./China trade negotiations from early May.
|U.S. Early Warning Signals Of U.S. Corporate Default Pressure|
|--Year ended Dec. 31--|
|U.S. unemployment rate (%)||3.8||3.9||3.7||4.0||4.1||4.1||4.7|
|Fed survey on lending conditions||2.8||(15.9)||(15.9)||(11.3)||(10.0)||(8.5)||8.2|
|Industrial production (% chya)||2.8||3.8||5.4||3.4||3.8||3.5||0.8|
|Slope of the yield curve (10-year less three-month, bps)||1.0||24.0||86.0||92.0||101.0||194.0||194.0|
|Corporate profits (nonfinancial, % chya)||14.3||19.6||15.8||15.1||7.3||7.3|
|Equity market volatility (VIX)||13.7||25.4||12.1||16.1||20.0||11.0||14.0|
|High-yield spreads (bps)||385.2||481.9||300.6||332.3||330.2||327.8||405.0|
|Interest burden (%)||10.1||10.1||10.6||11.0||10.9||11.5|
|S&P Global Ratings distress ratio (%)||7.0||8.7||5.7||5.1||5.4||7.4||24.8|
|S&P Global Ratings U.S. speculative-grade negative bias (%)||19.8||19.3||18.4||17.8||18.0||19.5||21.5|
|Ratio of downgrades to total rating actions (%)*||76.0||64.4||53.6||52.3||46.9||62.9||64.1|
|Proportion of speculative-grade initial issuer ratings 'B-' or lower (%)||34.7||33.3||28.6||30.0||34.3||24.1||29.7|
|U.S. weakest links (count)||154||148||150||149||142||151||176|
|Note: Fed survey refers to net tightening for large firms. *For speculative-grade entities only, excludes movement to default. S&P Global Ratings U.S. negative bias is defined as the percentage of firms with negative outlooks or CreditWatch statuses, of those with either negative, positive, or stable outlooks or CreditWatch statuses. CHYA--Change from a year ago. Bps--Basis points. Sources: Global Insight and S&P Global Fixed Income Research.|
On the flipside, lending conditions have largely improved in the last three months. The Fed's first-quarter 2019 Senior Loan Officer Opinion Survey recorded the first quarter of net tightening of lending conditions in eight quarters--coming in at a net 2.8% on commercial and industrial (C&I) loans (see table). However, the newly released April survey saw a sharp reversal, back into net loosening (4.2%) for C&I loan terms in the first quarter. Similar to most indicators of lending conditions, the reversal to more favorable loan conditions was prompted largely by a more favorable economic outlook relative to the prior three months, increased risk tolerance, and increased liquidity in secondary markets for loans. Competition from other, nonbank lenders also ranked high.
Consumers also remain optimistic. The unemployment rate hit a 50-year low of 3.6% at the end of April, down from 3.9% a year earlier. Wages and productivity are up, while inflation remains below 2%, and GDP growth came in at 3.2% in the first quarter. These factors are creating a rare combination of a strong economy amid low rates, with little on the horizon to prompt the Fed to increase rates anytime soon. In fact, a majority of market participants are currently pricing in a quarter-point cut by the Fed by year-end, as measured by the CME Group's FedWatch tool.
Leverage for U.S. corporations has held remarkably steady in recent years. The U.S. corporate interest burden has averaged 10.5% since the first quarter of 2013, marking an unusually long period of relative stability (see chart 6). We define the interest burden as net interest payments as a percentage of our EBITDA profits proxy (the sum of profits, consumption of fixed capital, and net interest payments). Despite the large borrowings in recent years, low interest rates and strong corporate profits have kept interest payments (as a percentage of income) at historically modest levels.
The relative risk of holding corporate bonds can be a major contributor to future defaults, since firms face pressure if they are unable to refinance maturing debt. One measure of this relative risk is the U.S. speculative-grade corporate spread, which reflects near-term market expectations for overall stress in the speculative-grade market. In broad terms, the speculative-grade spread is a good indicator of future defaults, based on a roughly one-year lead time (see chart 7). That said, at current spread levels, our baseline default rate forecast of 2.7% is above what the historical trend would suggest.
Given that spreads often reflect market liquidity and can be strong default indicators, it helps to get a sense of where they are relative to current economic and financial conditions. Bond spreads can reflect economic and financial market fundamentals but also investor sentiment, which can, at times, be fickle. Using a model based on the three broad measures of the VIX, the M2 money supply, and the Purchasing Managers' Index, we estimate that at the end of April, the speculative-grade bond spread in the U.S. was about 56 bps below where our model would suggest (see chart 8).
This gap also indicates that spreads are currently below where the larger economy and financial markets would suggest. Through most of the postrecession period, the spread was slightly higher than predicted. But the predicted level has exceeded the actual for 15 of the past 16 months--a phenomenon not seen since late 2007 through early 2008, right before spreads shot up past 1,000 bps, leading to a spike in the default rate roughly a year later. That said, during that time, the gap persisted for an extended period of three and a half years prior to a surge in spreads.
While the speculative-grade spread is a good indicator of broad market stress in the speculative-grade segment, defaults are generally rare during most points in the economic cycle outside of downturns. However, even in more placid conditions, there has never been a 12-month period with no defaults in the U.S. With this in mind, we feel a more targeted indicator of future defaults across all points in the credit and economic cycles is the corporate distress ratio (see chart 9).
The distress ratio (defined as the number of distressed credits, or speculative-grade issues with option-adjusted composite spreads of more than 1,000 bps relative to U.S. Treasuries, divided by the total number of speculative-grade issues) reflects market sentiment in much the same way as the overall spread level, but it focuses on the issuers perceived as facing extraordinary stress, even in relatively benign periods such as this. In fact, the distressed market has proved to be an especially good predictor of defaults during periods of more favorable lending conditions.
As a leading indicator of the default rate, the distress ratio shows a relationship that is broadly similar to that shown by the overall speculative-grade spread, but with a nine-month lead time as opposed to one year. The current distress ratio, at 6.1% in April, corresponds to a roughly 2.24% default rate for January 2020.
- High Tech Leads New Weakest Links, But Consumer Products Keeps The Overall Lead, May 22, 2019
- Retail Is The Most Distressed U.S. Sector, May 13, 2019
- 2018 Annual U.S. Corporate Default And Rating Transition Study, May 7, 2019
- 2018 Annual Global Corporate Default And Rating Transition Study, April 9, 2019
- U.S. GDP Growth Hits A Soft Patch--Not Quicksand, April 4, 2019
- U.S. Refinancing Study--$4.64 Trillion Of Rated Corporate Debt Is Scheduled To Mature Through 2023, Feb. 15, 2019
This report does not constitute a rating action.
|Global Fixed Income Research:||Diane Vazza, Managing Director, New York (1) 212-438-2760;|
|Nick W Kraemer, FRM, Senior Director, New York (1) 212-438-1698;|
|Research Contributor:||Abhik Debnath, CRISIL Global Analytical Center, an S&P Global Ratings affiliate, Mumbai|
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