S&P Global Ratings Research currently forecasts the U.S. speculative-grade corporate default rate will rise to 3.4% by June 2020 (see "The U.S. Speculative-Grade Corporate Default Rate Is Set To Rise To 3.4% By June 2020," Aug. 22, 2019). But past the first half of 2020, growing risks are laying the groundwork for a greater potential uptick in the default rate, which could eventually reach or exceed 10%.
The credit deterioration and corresponding debt buildup of recent years have been made possible by an extended period of ultralow borrowing costs for corporations. However, the current favorable credit cycle is showing signs of age and may have already turned. Corporate yields have risen since 2017, while economic and corporate profit growth have eased this year. Speculative-grade bond issuance has increased in 2019, but leveraged loans have been less popular due to the Federal Reserve lowering rates. This has led to an overall 11% year-over-year decline in combined speculative-grade bond and leveraged loan issuance through August.
The Yield Curve Inversion Bodes Ill For Default Rates
Our first indicator of a potential spike in the U.S. speculative-grade default rate is the inverted yield curve. An inversion of the yield curve--defined as the difference between the yields on 10-year Treasuries and three-month Treasuries--has been a reliable precursor to a recession in the U.S., having preceded the last seven recessions by an average of about 10 months. Though using a shorter available history, we can see that an inverted yield curve has also preceded the last three peak default cycles in which the default rate reached at least 10% (see chart 1).
The timing of inversions can vary ahead of a double-digit default rate. For example, when the default rate hit 10% in March 1991, the yield curve had first inverted in May 1989 (22 months ahead). During the next peak in the default cycle, the default rate reached 10% in October 2001, after the yield curve first inverted in July 2000 (15 months' lead time). Finally, when the default rate hit 10% in July 2009, it was preceded by an inversion of the yield curve that began in July 2006 (36 months ahead).
In 2019, the yield curve has been inverted at the close of every day but one since May 23 (through Sept. 16). Based on the prior three default cycles, this implies the default rate could hit 10% as early as August 2020 or as late as May 2022. The average lead time of inversions across all three prior peak default cycles is 24 months, which would place the default rate at 10% in May 2021.
The U.S. Spec-Grade Ratings Distribution Displays High Risk …
If the economy were to slip into a recession in the near future, the speculative-grade credit profile would be much weaker than at any comparable period in the past. A protracted period of exceptionally low borrowing costs, amid a now 10-year economic expansion, has led to a particularly weak speculative-grade ('BB+' or lower) ratings distribution (see chart 2).
At the end of the second quarter, the proportion of speculative-grade issuers with ratings of 'B-' or lower reached nearly 28%. This matches the high seen in the first quarter of 2009--a point in time already deep into the recession associated with the global financial crisis, and when the default rate was already rising. In March 2009, the speculative-grade default rate reached 5.8%, over twice the current rate of 2.5% and less than half its ultimate peak during that cycle (12.1% in November 2009).
This relative increase in credit risk in recent years appears to be attributable to every sector. In June 2007, the proportion of issuers rated 'B-' or lower among total speculative-grade issuers was 14.6%, and only telecommunications exceeded this proportion by a large margin (see chart 3). By June 2019, every sector's share of these lowest-rated issuers had increased, some markedly (see chart 4).
Given current market and economic conditions and industry-specific challenges, we expect the consumer services and leisure sectors to continue being prime contributors to defaults in the next down cycle. Historically, these sectors have led many default cycles, and retailers are still facing changing consumer tastes and online competition.
However, in the longer term, other sectors also pose risks. The high tech/computers/office equipment sector experienced a 90% pace of growth in initial speculative-grade ratings from 2007 to 2018. The high tech sector is also facing increased stress amid the ongoing U.S.-China trade dispute, with the next round of threatened U.S. tariffs reaching over $325 billion of goods, which would include cellphones and other high tech consumer goods (see "Latest Tariff Threat Would Be An Even Bigger Blow To The U.S. Tech Sector," Aug. 5, 2019). Currently, this threat has subsided somewhat, with many of these items subject to a delay in the implementation of tariffs, but we do not envision a long-term deescalation of this threat anytime soon (see "Tariff Delay A Respite For U.S. Tech," Aug. 14, 2019).
... Especially Considering The Growth Of Lower First-Time Ratings
The exuberance of credit markets in recent years has produced a record high ratio of first-time issuers rated 'B-' and below to total speculative-grade new issuers (excluding reemergences from prior defaults). The last such spike occurred in 2000, in the lead-up to the peak default rate of 11% in the 12 months ended April 2002 (see chart 5).
One of the largest shares of newly rated 'B-' or lower issuers in 2000 and 2001 came from the high tech sector (30% of the total), which later saw its speculative-grade default rate hit an all-time high of 12.3% in February 2002. Since the start of 2016, several sectors have contributed to the surge in new issuers with weaker ratings, but the high tech sector leads the way at roughly 25% of the total.
Broadly, when the proportion of issuers with 'B-' or lower initial ratings reaches a high point, the default rate rises roughly two years later. Assuming 2019 is one of these peak years for lower initial ratings--and that historical trends continue into the next downturn--this would loosely imply a peak default rate occurring at some point in 2021. In fact, the average time to default among all first-time issuers that began with ratings below 'B' is just short of four years.
Because we also expect the next peak default cycle to include a large proportion of distressed exchanges, there would be a high likelihood of repeat defaulters in the next cycle as well. Distressed exchanges and other forms of selective default contributed roughly 40% of defaults during the peak of the last cycle, in 2009 (see "How Distressed Exchanges Affect Default Rates And Ratings Performance," Sept. 26, 2011). If we were to include firms that reemerged from selective default (such as a distressed exchange) with a 'B-' or lower rating and subsequently defaulted again, the average time to default would fall to just over three years.
Past Cycles Offer Little Comfort
S&P Global Ratings' credit ratings exhibit a negative monotonic relationship with default rates: The lower the subsequent rating, the proportionately higher the historical default rate. This holds true when looking at long-term averages and at most points in the default rate cycle, particularly during peak default rates (see chart 6). This relationship between rating categories is described in and supported by our credit stability criteria (see "Methodology: Credit Stability Criteria," May 3, 2010).
However, while exhibiting cyclicality, the 'BB' default rate has been falling gradually over time. Meanwhile, the 'B' default rate has remained comparably consistent through various peaks and lows, continuing to hit an elevated level of roughly 13% during peak speculative-grade default rate periods. While this pattern is not a hard guide for the future, it is important to remember given the current ratings distribution and its large share of issuers at 'B-' or lower.
Near-Term Maturities Appear Manageable
With all this in mind, near-term maturing debt totals are broadly manageable for the remainder of this year and next (see chart 7). This has been a point of optimism because many issuers prepaid their near-term refinancing needs in the early days of the Fed's interest rate tightening campaign, while corporate yields remained little affected (see "U.S. Refinancing--$5.2 Trillion Of Rated Corporate Debt Is Scheduled To Mature Through 2024," Aug. 15, 2019). However, the increase in maturing debt could coincide with other risks mentioned above to produce growing headwinds for speculative-grade corporations for 2021 and beyond.
But Current Indicators Are Starting To Show Cracks
Though still on generally solid footing, the U.S. economy and financial markets have started to exhibit some vulnerabilities recently. 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 easily. 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 spread is a good indicator of future defaults based on a roughly one-year lead time (see chart 8).
Our estimated spread finished August at 582 basis points (bps), higher than the actual reading of 470 bps (see chart 9). This implies that the current spread is priced rather richly and that economic and financial conditions are riskier than the bond market currently suggests. Our estimated spread is based on economic and financial variables such as equity market volatility, the growth of the money supply, and the Institute For Supply Management's Purchasing Managers' Index. The aim is to capture various drivers of spread changes, such as liquidity, market sentiment, and economic fundamentals.
Generally, in the postrecession period, the actual spread has been higher than the estimate. But the estimated spread has exceeded the actual in 14 of the 20 months since the start of 2018. Additionally, S&P Global economists have recently raised their odds of a U.S. recession to a 30%-35% range over the next 12 months (see "U.S. Business Cycle Barometer: Recession Risk Rises," Aug. 15, 2019), though closer to the top of the range, given their augmented term-structure model signals a 35% risk of recession over the same period. Similar patterns were seen prior to the last recession, and the last time the gap between the estimated and actual spread reached its current level and duration--while also roughly coinciding with similar recession odds--was November 2007.
Is A Spike Avoidable?
The future of the U.S. speculative-grade corporate debt market will likely include several challenges, but no outcome is unavoidable, particularly over a multiyear horizon. Much will depend on two things: how the Fed reacts to a changing landscape and how corporations position themselves ahead of a possible downturn.
However, given rates are already low amid signs that inflation is warming, the Fed may be more limited in its options today than in the past, and could embark on a more stimulative monetary policy track over the near term. Markets generally expect the Fed to lower interest rates further by year-end, but not markedly. Additionally, the Fed is expected to conclude its reduction in its aggregate securities holdings in September. That said, there is nothing committing the bank to that course, and it could adopt much more aggressive measures in the future.
Firms have time to prepare for tax changes ahead. Corporations have received an extra boost from a recent--and permanent--tax cut. For now, the net interest deduction may be proving only a headwind for some, but over time, the working threshold will become more restrictive, particularly if coupled with falling earnings in an economic slowdown or recession. However, this will not happen overnight. Firms certainly have time to beef up cash stockpiles or reconfigure their funding structures to reduce leverage and avoid any material change that will likely take place in three to four years' time.
Ultimately, though, quantitative easing didn't prevent a spike in defaults last time. Even though the Fed cut rates to near zero in 2008-2009 and bought up massive amounts of U.S. Treasuries and mortgage-backed securities, the U.S. speculative-grade default rate still reached 14% in November 2009. However, the default rate then fell exceptionally quickly after hitting this peak, arguably with the help of the Fed's actions.
Appendix: Tax Reform Provides A Boost For Now But Could Pose Challenges In Years Ahead
Since the most recent U.S. presidential election, we've examined the tax profile of the speculative-grade population to get a sense of how changes in corporate tax structures might affect these issuers. We generally found the removal of the net interest deduction to be largely offset in most cases by the reduction in the statutory rate to 21%. Additionally, corporate profits rose substantially in 2018, in large part as a result of lower tax rates and fiscal stimulus, reaching a year-over-year growth rate of 11.3% in the third quarter. This should enable most companies to service their debt over the near term.
However, in coming years, determining the net interest deduction will become more restrictive once the current EBITDA basis is replaced with an EBIT-based one (see table). In both the current phase as well as in the future, net interest deductibility is limited to the first 30% of either EBITDA or EBIT. Generally, we expect this to have at most a modest impact on future defaults, with potential stress felt if this shift ends up coinciding with or closely following likely deterioration in economic conditions.
|Select Financial Ratios For U.S. Nonfinancials|
|Data as of:||Rating category||Average interest expense/EBITDA (%)||Median interest expense/EBITDA (%)||Average interest expense/EBIT (%)||Median interest expense/EBIT (%)|
|Aug. 21, 2019||BB||16.2||14.4||25.7||21.1|
|Oct. 3, 2018||BB||15.1||13.9||22.4||18.8|
|Dec. 11, 2017||BB||15.4||14.5||25.0||20.4|
|Sources: S&P Global Ratings Research and S&P Global Market Intelligence.|
Some fluctuation in the financial ratios above is expected from year to year. This is particularly true for the 'CCC'/'C' segment, where very few companies post taxable profits, greatly limiting the sample on which to base these estimates.
- Methodology: Credit Stability Criteria, May 3, 2010
- The Expansion Of The 'B-' Segment Is Feeding Growing Vulnerabilities, Sept. 25, 2019
- The U.S. Speculative-Grade Corporate Default Rate Is Set To Rise To 3.4% By June 2020, Aug. 22, 2019
- U.S. Business Cycle Barometer: Recession Risk Rises, Aug. 15, 2019
- U.S. Refinancing--$5.2 Trillion Of Rated Corporate Debt Is Scheduled To Mature Through 2024, Aug. 15, 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
- How Distressed Exchanges Affect Default Rates And Ratings Performance, Sept. 26, 2011
- Recent Policy Proposals' Potential Impact On U.S. Corporate Bond Issuance, Jan. 31, 2017
This report does not constitute a rating action.
|Ratings Performance Analytics:||Nick W Kraemer, FRM, New York (1) 212-438-1698;|
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