S&P Global Ratings Research expects the 12-month trailing default rate for speculative-grade European corporate issuers (financial and nonfinancial) to rise to about 2.8% by June 2020. This would be roughly half a percentage point higher than the current 2.3% rate, representing a reversal in the gradual downward trend experienced since mid-2017 (see chart 1). Nonetheless, this forecast is still slightly below the long-term (since 2002) average default rate of 3.1%. Under our optimistic scenario, the speculative-grade default rate would be 2.04% (14 defaults), while in our pessimistic scenario, the default rate would be 3.5% (24 defaults).
Some ratings-based indicators suggest rising aggregate default risk. Over the past few years, there has been a noticeable shift in the ratings distribution, with a rising share of lower ratings within the speculative-grade category ('BB+' or lower). Most of the shift has occurred at the 'B' level, often resulting from financial underperformance relative to S&P Global Ratings' expectations and leverage rising above our guided thresholds. Additionally, about 11% of first-time-rated speculative-grade issuers each year in Europe are rated 'B-'.
We also expect heightened downgrade potential across many sectors and countries over the next year. The combination of a weaker ratings distribution and increased downgrade potential should result in a higher default rate. Against currently unstable global and regional political conditions, these credit risks could increase.
A recent source of optimism, however, is the announcement that the European Central Bank (ECB) will embark on a multipronged approach to extend favorable financing conditions to help boost the economy. Still, it seems that thus far the positive effects of lower policy rates, potential asset purchases, and a new round of targeted longer-term refinancing operations have been mostly enjoyed by safer assets, such as sovereign and investment-grade (rated 'BBB-' or higher) corporate debt.
Financing Conditions Are Generally Favorable, But Risks Are Increasing
Despite increased capital market volatility at the end of 2018 and expectations for slowing economic growth, most measures of financing conditions remain favorable in Europe. Thus far, this is largely a consequence of this year's supportive language from the ECB, which has driven many interest rates to exceptionally low levels. Corporate spreads have fallen back from their levels at the start of the year, and bank lending conditions have generally stayed accommodative, though the most recent ECB euro area bank lending survey for enterprises reported tightening conditions in the second quarter.
Rising concerns over the future economic outlook, as well as increased risk aversion, prompted the shift to tighter internal guidelines and loan approval criteria. Meanwhile, funding conditions remain favorable, and loan demand has continued to increase. This extended favorable backdrop has led to the long period of low defaults in the region for the past several years (see chart 2).
Recent Issuance Far Exceeds Near-Term Maturities
Favorable lending conditions in recent years were fueled by a combination of accommodative monetary policy from many developed economies' central banks and a subsequent hunt for yield among investors, which helped push borrowing costs down. An additional consequence has been the general reduction of maintenance covenants on leveraged loans. This has helped keep the default rate in Europe both relatively low and stable in recent years. It has also provided many speculative-grade-rated firms with ample opportunity to issue debt (see chart 3).
Combined speculative-grade bond and leveraged loan issuance in Europe has been averaging €180.3 billion annually since 2013, with 2017 coming in at a high of €244.3 billion. Outside of that year's particularly strong total, debt issuance among the most leveraged firms has generally remained stable, around an average of €167.5 billion annually.
Upcoming debt maturities for European speculative-grade borrowers appear to be manageable for the next few years (see chart 4). All things being equal, this should limit the number of firms that may find themselves unable to refinance in a potential economic downturn or prolonged episode of heightened market volatility. In such cases, it is typical for funding to freeze up for riskier borrowers.
That said, a total of €68.8 billion in outstanding speculative-grade debt is set to come due through 2020, with another €65.5 billion due in 2021--far lower than the total of €185 billion in speculative-grade bond and leveraged loan issuance in 2018 alone. Further, over time, some issuers pay down their outstanding principal early, particularly amid low interest rates. However, maturing debt amounts rise noticeably beginning in 2022.
Healthy issuance alongside easier financing terms should provide support for a lower default rate. However, some changes in recent years may complicate the picture over the next default cycle, such as the introduction of new accounting standards (notably International Financial Reporting Standard [IFRS] 9) and the recent prevalence of covenant-lite leveraged loans. We think bank lenders providing leveraged loans will be less supportive of vulnerable companies during the next credit downturn because the risk-return trade-off has become less attractive, for two reasons.
First, under IFRS 9--which took effect in January 2018--banks have started provisioning on the basis of expected credit loss. For performing loans, this means provisioning for just 12 months. However, when a credit becomes stressed and is classified as underperforming (or "stage 2"), required provisions increase significantly to cover the full expected credit loss over the lifetime of the loan.
The second reason is that the great majority of term loans are now covenant-lite, and even though institutional investors have grown in dominance, European banks still participated in 16% of term loan primary volumes in the first half of the year, according to data from S&P Global Market Intelligence's Leveraged Commentary & Data. This reduces the ability of lenders to receive amendment fees and reset margins. And for revolving credit facilities, while financial maintenance covenants still prevail, their effectiveness is reduced in many cases by the use of carve-outs, high covenant triggers, and equity cures, among other devices.
In our view, these changes mean that bank lenders will have less incentive to remain committed to vulnerable credits in the event of a drop in credit quality. This could encourage distressed sales to other investors and be detrimental to the liquidity positions of the companies, with the consequence that, over time, default risk would be higher.
But A Rising Concentration Of Lower Ratings Increases Vulnerabilities
A potential indicator of changing credit risk across speculative-grade European corporates is the evolving ratings distribution. Over the past 14 quarters, we have seen a net increase in the concentration of ratings at lower levels, likely indicating higher credit risk on average.
The proportion of speculative-grade issuers rated 'B-' or lower reached 18.1% by number in June, compared to 13.8% at the end of 2015. In fact, the proportion of speculative-grade issuers rated 'B-' or lower remained at or above 18% in the first half of 2019, peaking at 18.6% in April. The last time this proportion reached 18% was during the financial crisis (see chart 5).
The distribution of speculative-grade ratings has generally shifted toward lower ratings since mid-2012. In absolute terms, the number of issuers we rate 'B' and below has more than quadrupled over the past eight years, rising to account for 54% of speculative-grade ratings as of June, from just 31% at end-2010.
The changing ratings distribution over this period was largely due to new issuers joining the pool of speculative-grade ratings, rather than solely due to the deteriorating credit quality of previously rated issuers (see table). Nonetheless, such a structural shift in the ratings distribution would likely increase the aggregate speculative-grade default rate in a credit downturn (depending to some extent on the vintage of new leveraged buyout transactions), all else being equal, because realized default rates are typically higher for lower rating levels.
|First Ratings Distribution Of Issuers Currently Rated 'B-' Or Lower|
|Data as of July 21, 2019. Sources: S&P Global Ratings Research and S&P Global Market Intelligence's CreditPro®.|
Downgrade Potential Is Elevated Across Most Sectors And Countries
Another consideration in our forecast for the speculative-grade default rate is the negative ratings bias, which we define as the proportion of outstanding ratings with negative outlooks or on CreditWatch with negative implications. The negative bias for speculative-grade European corporate issuers was 14% in June, up slightly from 12.5% at the end of 2018 but still well lower than the 23% average since 2003.
Though still low by historical standards, the negative bias can vary greatly by industry. Ultimately, many of the largest sectors within the speculative-grade segment are likely to see increased downgrades over the next 12 months, and typically downgrade momentum precedes defaults. Chart 6 presents net rating actions (the upgrade rate minus the downgrade rate) over the prior 12 months against the net rating bias (current positive bias, or the proportion of issuers with positive outlooks or ratings on CreditWatch with positive implications, minus current negative bias) by sector.
Those sectors in the southwest quadrant have both a higher rate of recent downgrades as well as a higher net negative bias than a positive one. By this measure, seven (of 13) sectors are showing increased downgrade potential, and together they account for 77.1% of the speculative-grade population.
The six sectors with the most aggressive potential downgrade momentum are aerospace, autos, capital goods, and metals; energy and natural resources; health care/chemicals; high tech, computers, and office equipment; leisure time and media; and telecommunications. In addition to their heightened pace of recent downgrades and higher downgrade potential, they make up 63% of the 'CCC'/'C' population--the riskiest set of issuers rated. With the addition of consumer products, this proportion jumps up to 91.4% of the 'CCC'/'C' rating category.
Just as downgrade potential varies by sector, it also depends on the country of the issuer. Our rated population is concentrated among the top few leading countries, particularly the U.K. and associated tax havens, which account for roughly 28% of current speculative-grade issuers. Chart 7 shows the relative downgrade risk of the 10 largest countries by issuer count, in the same way as chart 7 did by sector. Together, these 10 countries account for roughly 88% of total speculative-grade issuers.
Protracted Brexit-related uncertainty is continuing to weigh on the U.K.'s economic performance, so the high number of U.K.-domiciled entities in our rated speculative-grade portfolio is adding to our deteriorating credit outlook.
Economic Growth Persists But Is Expected To Slow
Our default rate projection considers various macroeconomic indicators, and European growth trends are expected to moderate in upcoming years. Two of the largest countries, Germany and Italy, are expected to see only minimal growth in 2019, at 0.5% and 0.1%, respectively. Their performance is weighing on S&P Global economists' overall expectations for 2019, which are 1.2% for the eurozone. This slower growth trend is expected to continue into 2020, when S&P Global economists expect to see growth of only 1.1% in the eurozone (see "Low Growth And Lower Rates: The Eurozone In 2020," Sept. 26, 2019).
In general, risks to growth are tilted to the downside. In particular, the eventual outcome of the U.K.'s Brexit process could have a significant bearing on economic prospects, particularly in the event of a "no-deal" scenario, which would be highly disruptive for trade and businesses. As a base case, we expect that U.K. economic growth will be 1.2% in 2019, although this is contingent on a deal being struck with the EU (see "The Eurozone's Open Economy Makes It More Vulnerable To Escalating Trade Conflicts," June 26, 2019). Through the next 12 months, further risks include global trade tensions, the Italian budget law, low inflationary pressures, and a deceleration in global trade.
Appendix: Scope And Approach
This study covers both financial and nonfinancial speculative-grade corporate issuers (those with a rating of 'BB+' or lower).
The scope and approach are consistent with our default and rating transition studies. In this report, our default rate projection incorporates input from S&P Global economists, which we also use to inform the analysis of our regional Credit Conditions Committees.
We determine our default rate forecast for speculative-grade European financial and nonfinancial corporates based on a variety of quantitative and qualitative factors. The main components of the analysis are credit-related variables (for example, negative ratings bias and ratings distribution), the ECB bank lending survey, market-related variables (for example, corporate credit spreads and the slope of the yield curve), economic variables (for example, the unemployment rate), and financial variables (for example, corporate profits). For instance, increases in the negative ratings bias and the unemployment rate are positively correlated with the speculative-grade default rate. As the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications increases, or the unemployment rate rises, the default rate usually increases.
This report covers issuers incorporated in any of the 31 countries of the European Economic Area, Switzerland, or certain other territories, such as the Channel Islands. The full list of included countries is Austria, Belgium, the British Virgin Islands, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Gibraltar, Greece, Guernsey, Hungary, Iceland, Ireland, the Isle of Man, Italy, Jersey, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, Monaco, Montenegro, the Netherlands, Norway, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, Switzerland, and the U.K.
- Low Growth And Lower Rates: The Eurozone In 2020, Sept. 26, 2019
- New ECB Stimulus Package Is Likely To Keep Interest Rates Low Through 2023, Sept. 13, 2019
- Argentine Companies Boost The Weakest Links Tally To Its Highest Since 2016, Sept. 11, 2019
- Credit Conditions In EMEA Show Underlying Fragility Beneath A More Stable Surface, Report Says, June 27, 2019
- The Eurozone's Open Economy Makes It More Vulnerable To Escalating Trade Conflicts, June 26, 2019
- 2018 Annual Global Corporate Default And Rating Transition Study, April 9, 2019
- 2017 Annual European Corporate Default Study And Rating Transitions, Sept. 5, 2018
- Weakest Links Are Nearly Ten Times More Likely To Transition To Default Than Speculative-Grade Entities, Feb. 27, 2013
This report does not constitute a rating action.
|Ratings Performance Analytics:||Nick W Kraemer, FRM, New York (1) 212-438-1698;|
|Kirsten R Mccabe, New York + 1 (212) 438 3196;|
|European Corporate Research:||Paul Watters, CFA, London (44) 20-7176-3542;|
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