Chart 1

S&P Global Ratings Research expects the European trailing-12-month speculative-grade corporate default rate to increase to 8.5% by March 2021 from 2.7% as of April 2020 (see chart 1).   Since our last update to the European default forecast in March, S&P Global economists have lowered their expectations for European economic performance amid the COVID-19 pandemic. We also saw both an uptick in defaults as well as a historically high number of downgrades and negative outlook and CreditWatch placements in April. Our speculative-grade population is being particularly hard hit globally, as a result of the virus, social distancing measures to fight it, and the acute stress in the oil and gas sector from collapsing oil prices. We expect this general deteriorating credit trend to continue as many firms, particularly speculative-grade (rated 'BB+' or lower) companies in some of the weakest and most affected sectors, find their solvency stretched amid falling revenue.

In our pessimistic scenario, we forecast the default rate will rise to 11.5%.   In this scenario, we anticipate either the economic drag will extend beyond the second quarter of 2020 or the subsequent recovery will be slower than S&P Global economists' base case. A possible resumption of COVID-19 cases later this year or early next, which would ultimately put extreme stress on many leveraged firms and households, could further complicate this scenario. This would result in a longer period of suppressed consumer spending, negligible business investment, and a longer period of higher unemployment.

In our optimistic scenario, we forecast the default rate will rise to 3.5%.   Here we turn our expectations to be roughly in line with what market signals are implying about future default activity. Compared with our base-case assumptions, fixed-income markets appear much more optimistic, given current risk pricing in the speculative-grade space. Similar to the observations in the U.S., increased market liquidity support from central banks, fiscal support for many national economies, a recent slowing pace of new infections regionally, and encouraging news regarding vaccine and treatment research are all being priced in to credit markets.

Base Case: Credit And Economic Deterioration Leads To More Defaults

In the first quarter of the year, downgrades among speculative-grade companies rose markedly, particularly in March. This continued in April as well, amid the stress of falling revenue due to the demand shock from social distancing measures and collapsing oil prices. Within the European speculative-grade population, sectors most vulnerable to social distancing--such as retail, consumer products, and leisure--constitute a particularly large portion of the total (34%).

These aggregate downgrades have resulted in a noticeable increase in companies rated 'B-' and lower (see chart 2). The proportion of speculative-grade companies rated 'B-' and lower reached an all-time high of 31% at the end of April, topping the previous high from the start of the year by nearly 10 percentage points.

Chart 2

The proportion of new issuer credit ratings at 'B-' and lower has also been increasing in recent years in Europe (see chart 3).   The upswing in this ratio since 2017 has coincided with recent years' increase in collateralized loan obligation (CLO) issuance, providing ready demand for new debt. Periods of growth in the proportion of the lowest ratings among newly rated speculative-grade issuers has coincided with prior increases in the default rate. That said, the default rate has remained stubbornly subdued and may be overdue for an increase based on this relationship, particularly in light of the deep economic stress presented by the COVID-19 pandemic.

Chart 3

Within the speculative-grade segment, most of the largest sectors are likely to see increased downgrades over the next 12 months, and typically downgrade momentum precedes defaults.   Some sectors experienced net downgrade rates of 20% or more in the 12 months ending in April, with many also showing a net negative bias in excess of 40% (see chart 4). Both of these measures imply particularly harsh credit conditions and expectations for this to continue. This is most obvious in sectors under the greatest stress as a result of the virus and collapsing oil prices: leisure time/media, consumer services, transportation, and energy and natural resources.

Chart 4

At a country level, credit stress and future expectations are much more similar, relative to each sector (see chart 5). The relative impact of conditions in the U.K. is likely to have a larger impact on our European population given the large proportion of companies we rate from that country. Alongside the European Central Bank (ECB), the Bank of England (BoE) has also embarked on a series of recent actions in support of market liquidity and access to borrowing, such as expanding the Asset Purchase Program, relaxing capital requirements at banks, and creating the Covid Corporate Financing Facility.

Chart 5

The 12 months ending April 2020 has produced the highest level of credit deterioration since the peak of the 2008-2009 financial crisis (see chart 6). Currently, the net downgrade rate and the net bias are reflecting heightened downgrades and increased prospects for future downgrades as the impact of the coronavirus and resultant social distancing measures sap earnings and strain cash flow, particularly for the weakest issuers.

To put the current level of credit deterioration in historical context, the 12-month period ending in April saw roughly an equivalent level of credit stress as the fourth quarter of 2009. During the financial crisis, the European speculative-grade default rate peaked in November 2009, during middle of the same quarter, reaching 10%. That said, at that time, the pace of credit deterioration was improving from prior quarters. It remains to be seen if the current pace of downgrades and negative bias have reached a peak, but the downward momentum from only as recently as March is extreme.

Chart 6

Given the broad-based credit deterioration that's continued into the second quarter, defaults will likely be elevated in several sectors compared with recent years, when defaults were relatively muted outside of energy and natural resources, and consumer services sectors. Through April, 71% of this year's defaults have come from sectors beyond energy and natural resources, and consumer services (see chart 7). Through most years in the past six, these two sectors have accounted for a majority of the annual default totals in the European speculative-grade population. As a percentage of the total, they are currently at a very low rate; however, it is likely they will see an increase in coming months given their relative vulnerabilities in the face of social distancing and the recent surge in global oil production.

Chart 7

Through the 12 months ended April 30, the speculative-grade default rate reached 2.7%. This was the result of 18 defaults over the period beginning May 1, 2019, and is the highest default rate since the 12 months ending January 2014. This is still below our long-term average default rate (since January 2002) of 3.1%, but it's proportionately well above the 2% average default rate over the protracted period of a relatively stable default rate from 2011.

Optimistic Scenario: Market Sentiment And Extraordinary Support Keep Defaults Subdued

Alongside the ECB's Pandemic Emergency Purchase Program (PEPP), the Federal Reserve in the U.S. also engaged in various programs to provide liquidity to fixed-income markets. This was a new venture by the Fed, and markets have reacted exuberantly since, with investment-grade corporate bond issuance surging $585 billion since the March 23 announcement. Speculative-grade bond issuance has also resumed in April and May. That said, the high-yield bond and leveraged loan primary markets are still languid in Europe (see chart 8). March and April essentially saw little to no issuance, with only $1.3 billion in April.

Chart 8

While at first glance it may appear that funding for speculative-grade companies may remain stalled, even after the introduction of the PEPP, primary high-yield and leveraged loan markets may not tell the whole story. Beyond the PEPP, the ECB and relevant authorities have introduced a number of other supportive measures. These have included easing the conditions for accessing long-term refinancing operations and providing more flexible regulatory support to ensure liquidity continues to flow to the private sector. We therefore expect that European banks will play a pivotal role in channeling funding to meet solvent corporations' financing requirements through the extension of credit lines and other borrowing facilities. Additionally, the ECB has just expanded the amount included in the PEPP by an additional €600 billion, bringing the total up to €1.35 billion while also extending the program out another six months, to June 2021. It remains to be seen what the impact may be on European financial markets; however, it is reasonable to expect this to further support market liquidity and access to credit.

Indeed, recent ECB data appears to support this likelihood. Loans to nonfinancial corporations hit an all-time high in March at €128.2 billion, with another €75.4 billion in April--the second-highest monthly total after March (see chart 9).

Chart 9

Despite such large figures, there are a few potential limitations. First, it is unclear how much of the new loan total is attributable to speculative-grade firms. Secondly, it is likely a large portion of the total in March and April may be drawdowns of revolving credit facilities in an effort by firms to maintain liquidity through the crisis. The breakdown of the ECB lending data appears to support this: 45% of the new loans to nonfinancial corporations in March have a maturity of less than one year. Nonetheless, if we were to apply a 55% rate to the €128 billion figure for March, this results in €58 billion--a high not seen since before the financial crisis.

In addition to a surge in new loans, expectations for lending conditions moving forward are quite supportive for loan issuance over the medium term. In the most recent ECB bank lending survey from the first quarter, lending conditions unsurprisingly showed tightening amid the pandemic outbreak in Europe. But expectations for the future reflect a substantial loosening of terms and conditions over the next quarter (see chart 10). At an absolute level, the survey's reading of a net 10.6% loosening for the coming quarter is one of the highest since the series began in 2003. When considering this expected rate of net loosening against the actual level of net tightening in the most recent quarter, this represents the largest difference between the two measures in the survey's history (4.3%, and -10.6%, for a difference of nearly 15% in absolute terms). If projections prove true, this shows loans to corporations will provide some needed liquidity support in the near term.

Chart 10

But what about for high-yield bonds? As mentioned, bond issuance remains sparse for European corporate issuers. Nonetheless, secondary market pricing is also reflecting a positive shift ahead (see chart 11). The relative risk of holding corporate bonds can be a major contributor to future defaults because firms face pressure if they are unable to refinance maturing debt. In broad terms, the speculative-grade spread is a good indicator of future defaults based on a roughly one-year lead time. That said, at current spread levels, our baseline default rate forecast of 8.5% is well above what the historical trend would suggest.

Chart 11

Are Markets Getting Ahead Of Things?

Similar to what we're observing in the U.S., it is possible bond investors are more optimistic than the underlying economy and financial markets suggest. Using a model based on broad measures of financial market sentiment, economic activity, and liquidity, we estimate that at the end of April, the speculative-grade bond spread in Europe was about 480 basis points (bps) below where our model would suggest (see chart 11).

This is one of the largest gaps between the actual and estimated spread since our series began in 2003 and could indicate that spreads are currently far below where the larger economy and financial markets would suggest. This divergence, taken into consideration with the European economic outlook and the fundamental credit backdrop for speculative-grade issuers, raises doubt that risk is adequately priced into markets.

Chart 12

Just as the nature of the current stress caused by the coronavirus is particularly unusual and difficult to predict, so too are the potential upsides to the current situation.   Markets have not only been reacting positively to central bank facilities and fiscal assistance programs, but also to a falling number of active virus cases regionally. The potential benefits of reduced new virus cases and development of treatments or vaccines will not show up in traditional economic data such as the PMI, but only indirectly through financial market optimism. Some other high-frequency data such as driving patterns/volumes may also give indications of increased social mobility and a turning around of the economy. Although a vaccine is still estimated to be some time away, research at this point appears promising, as does emergency use of some treatment methods.

Pessimistic Scenario: Downside Risks Are Still Considerable

In our pessimistic scenario, we anticipate the default rate could reach 11.5% (84 defaults) by March 2021.   Here we assume either a resumption of the virus and an increased caseload later in the year or in early 2021, or a slower recovery from the current global recession. European exports are vulnerable to declining travel, with tourism hit particularly hard as the opening of regional borders is likely to be a late-stage development in a drawn-out process of lifting social distancing measures. The potential for a protracted period of low oil prices is also a risk, as OPEC countries contribute much to the region's export total. Given that the base-case trajectory is for only two-thirds of economic losses to be recovered by 2021, and a return to trend growth only in 2023, there is a lot of room for further stress to manifest itself in a material way for weaker borrowers.

All of this would put greater stress on cash flow and require firms to look to issue new debt at a time of increased hardship and uncertainty, which would either lead to higher borrowing costs or another closing of the primary markets. In such a scenario, central banks would almost certainly be expected to provide more market liquidity, but considering any positive impact thus far has been indirect or difficult to observe for the speculative-grade segment, and any future benefit from monetary policy may be muted for weaker issuers. In this scenario, we expect historical default rates for 'B-' and 'CCC/C' rated issuers to expand to new highs.

Unprecedented Times Push Increased Uncertainty

Because of the wide range of possibilities, it is perhaps more appropriate to think of these as separate possible outcomes rather than simply a range on a central theme.   Given the unprecedented nature of the virus, resulting containment measures, fiscal and monetary responses thus far, and the uncertain path ahead for all of these factors, it is also possible that regardless of which of these three outcomes is more accurate, defaults could follow a path resembling an elevated plateau, as opposed to the historical peak-and-trough cycles of the past.

Whether through drawdowns on credit lines, increased bond issuance, or via new bank loans, most liquidity support for speculative-grade companies is likely coming in the form of debt rather than subsidies. It is also important to consider that revolving lines of credit may only provide a proportionately small or short-lived solution to a need for cash. We estimate that of the European speculative-grade companies we rate, only about 4% of their total outstanding debt (as of the start of this year) was accounted for by the full amounts available of outstanding revolvers. If the need for further stimulus arises, it will likely come during a period of reduced revenue, making for even higher debt burdens moving forward, which either will have to be financed through even more debt or will require organic revenue to grow at a faster pace than in the past. Even in S&P Global economists' base case, a faster pace of organic revenue generation is unlikely, given the expectation for a drawn-out economic recovery.

If a more drawn-out recovery does take place, refinancing obligations may become more difficult to repay, particularly for the weakest borrowers. Additionally, if direct subsidies to protect solvency are employed, they will likely come at the expense of additional debt for sovereigns, which could raise benchmark borrowing costs in the future, and potentially crowd out highly levered corporate borrowers.

How We Determine Our European Default Rate Forecast

Our European default rate forecast is based on current observations and on expectations of the likely path of the European 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 3.5% in March 2021 (25 defaults in the trailing 12 months) in our optimistic scenario and 11% (80 defaults in the trailing 12 months) in our pessimistic scenario.

This study covers both financial and nonfinancial speculative-grade corporate issuers.

The scope and approach are consistent with our other ratings performance research publications globally, that is, our default and ratings transition studies. In this report, our default rate projection incorporates inputs from our economists that 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 companies 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 example, 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.

By geography, this report covers issuers incorporated in any of the 31 countries of the European Economic Area (EEA), 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.

Related Research

• The U.S. Speculative-Grade Corporate Default Rate Is Likely To Reach 12.5% By March 2021, May 28, 2020
• The European Crisis Backstop Is Underpinning Corporate Funding Conditions, May 19, 2020
• Credit Conditions In Europe Darken As Costs Of Lockdowns Add Up, April 27, 2020
• Europe Braces For A Deeper Recession In 2020, April 20, 2020