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Default, Transition, and Recovery: The Gap Between Market Expectations And Credit-Based Indications Of U.S. Defaults Is Growing


Default, Transition, and Recovery: The U.S. Leveraged Loan Default Rate Could Climb To 2.75% By June 2024 As Economic Growth Grinds Lower


Default, Transition, and Recovery: Corporate Defaults Record Highest August Total Since 2009


Default, Transition, and Recovery: The European Speculative-Grade Corporate Default Rate Could Rise To 3.75% By June 2024


Default, Transition, and Recovery: The U.S. Speculative-Grade Corporate Default Rate Could Rise To 4.5% By June 2024

Default, Transition, and Recovery: The Gap Between Market Expectations And Credit-Based Indications Of U.S. Defaults Is Growing

Chart 1


S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to rise to 12.5% by June 2021 from 5.4% as of June 2020 (see chart 1).   Our economists think the U.S. economy will see growth in the third quarter, but high-frequency data paints a mixed picture, which is severely challenging the 22.2% annualized growth rate expected this quarter. We also saw both an uptick in defaults as well as a historically high number of downgrades and negative outlook and CreditWatch placements in the second quarter. The pace of downgrades and negative outlooks and CreditWatch listings has slowed significantly since April but is still elevated relative to the pre-COVID-19 pace in February.

In our pessimistic scenario, we forecast the default rate will rise to 15.5%.  In this scenario, we anticipate the economic drag will markedly suppress the recovery, making the rebound both longer and lower than S&P Global economists' base case. A possible national 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, with a lengthier period of high unemployment.

In our optimistic scenario, we forecast the default rate will fall to 4%.  Here we turn our expectations to roughly reflect what market signals are implying about future default activity. Compared with our base-case assumptions, fixed-income markets appear very optimistic given current risk pricing--even among the weakest issuers. This is likely resulting from continued faith in the ability of the Federal Reserve's new liquidity facilities to provide a stable tailwind, encouraging news regarding vaccine and treatment research, and, perhaps, the expectation that if the economy faces continued stress from new waves of infection, the government and the Fed will once again provide support.

Base Case: Credit Deterioration Now At An All-Time High

After an already busy first quarter of the year, downgrades among speculative-grade companies rose at their fastest quarterly pace in the three months ended in June, led by a surge of downgrades in April. Since May, the pace of downgrades has eased considerably, but it's still not back down to the rate we saw in February before the COVID-19 outbreak in the U.S.

Two successive quarters of some of the largest downgrade rates in history have resulted in a noticeable increase in companies rated 'B-' and 'CCC' to 'C' (see chart 2). The proportion of speculative-grade companies rated 'B-' and lower reached an all-time high of 40% at the start of the third quarter, topping the previous high from the prior quarter by a full five percentage points. Meanwhile, the proportion of speculative-grade issuers rated 'CCC/C' has also hit an all-time high of 16.2% at the end of the second quarter--more than twice the proportion at the same time last year. Given such a high proportion of weak ratings, this strongly supports a high default rate in the next 12 months.

Chart 2


Within the speculative-grade segment, most sectors are likely to see increased downgrades over the next 12 months--typically downgrade momentum precedes defaults.  Some sectors in the second quarter experienced net downgrade rates of 30% or more, with most of these also showing a net negative bias above 50% (see chart 3). Both of these measures imply particularly harsh conditions for creditworthiness and expectations for this decline 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.

In June, the net bias (positive bias minus negative bias) fell further to -50% as the negative bias for all speculative-grade companies reached 52.4%. At the end of July, the net bias remained at -50%, with the negative bias at 52.3%. May marked an all-time high for the negative bias (at 52.5%), breaking the prior high of 47% from March 2009. And at this point, the negative bias has only improved incrementally, while the net bias is at its all-time high as the positive bias has continued to fall, reaching a historical low of 2.2% in July.

Chart 3


Second-quarter 2020 produced a level of credit deterioration greater than even during the financial crisis of 2008-2009 (see chart 4). 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.

That said, net downgrades and net negative bias measures have both been easing since their peak in April. Although too early to tell, this may prove to be a turning point in the pace of credit deterioration, possibly suggesting a peak default rate is on the horizon in the next two to three quarters.

Chart 4


Despite Marginal Improvement, Default Signs Still Flashing Red

Economic and financial conditions are mixed, with some improvement since the beginning of the second quarter. The unemployment rate has come in lower recently as initial jobless claims have come down somewhat, but even so, they're still at extremely high levels. Market volatility, as measured by the VIX, has slowly moved lower over the past three months from a level around 30 but remains above levels that typically prevail during economic expansions. Our distress ratio has come down, but it's by no means low. High-yield spreads have declined from the first quarter, but ratings metrics continue to indicate that default risk is elevated. Lending conditions have tightened further in the latest report from the Fed, with the proportion of respondents tightening standards reaching the highest level since third-quarter 2008.

While we've seen marginal improvement in some economic and financial data since the first quarter, there is still a considerable amount of downside risk for the economy and financial markets.

U.S. Early Warning Signals Of Default Pressure
2020Q2 2020Q1 2019Q4 2019Q3 2019Q2 2019Q1 2018Q4 2018Q3 2018Q2 2018Q1
U.S. unemployment rate (%) 11.1 4.4 3.5 3.5 3.7 3.8 3.9 3.7 4.0 4.0
Fed Survey on Lending Conditions 41.5 0.0 5.4 (2.8) (4.2) 2.8 (15.9) (15.9) (11.3) (10.0)
Industrial Production (% chya) (10.8) (4.8) (0.8) (0.2) 1.0 2.3 3.8 5.4 3.4 3.8
Slope of the yield curve (10-yr less 3-month, bps) 50 59 37 (20) (12) 1 24 86 92 101
Corporate profits (nonfinancial, % chya) (5.7) 1.3 (0.3) 0.5 (3.3) 5.8 8.6 9.2 11.4
Equity market volatility (VIX) 30.4 53.5 13.8 16.2 15.1 13.7 25.4 12.1 16.1 20.0
High-yield spreads (bps) 635.9 850.2 399.7 434.1 415.6 385.2 481.9 300.6 332.3 330.2
Interest burden (%) 7.9 7.5 7.7 7.7 7.9 7.7 8.0 8.6 9.4
S&P Global distress ratio (%) 12.7 35.2 7.5 6.2 6.1 8.6 8.7 5.7 5.1 5.4
S&P Global U.S. speculative-grade negative bias (%) 52.4 37.1 23.2 21.4 20.3 19.8 19.3 18.4 17.8 18.0
Ratio of downgrades to total rating actions (%)* 95.2 90.4 82.9 82.9 69.6 76.0 69.0 52.8 62.2 54.3
Proportion of speculative-grade initial issuer ratings 'B-' or lower (%) 67.2 55.6 40.4 38.9 41.3 38.3 33.3 29.3 31.8 34.7
U.S. weakest links (#) 432 318 196 179 167 151 145 145 144 138
Note: Fed Survey refers to net tightening for large firms. *For speculative-grade entities only, excludes movement to default. S&P Global Ratings outlook distribution defined as ratio of firms with negative bias compared with firms with positive bias. Sources: Global Insight and S&P Global Ratings Research.

Default Tally Already Tops 2019's Total

Through the first half of 2020, we've already seen more downgrades than any full annual period on record. We entered the year with the proportion of speculative-grade issuer ratings near all-time highs. These issuers have been affected most by the recession, accounting for nearly 85% of downgrades. Rating trends also show that the weakest speculative-grade issuers have been disproportionally affected. About one-third of issuer downgrades have been transitions to 'B-' or lower from 'B+' or 'B'. The proportion of issuers rated 'B-' or lower at the end of second-quarter 2020 was just below the all-time high set in May and suggests default risk remains elevated.

The total number of defaults reached 83 through the end of second-quarter 2020, already surpassing 2019's annual total of 78 (see chart 5). We expect defaults to be elevated in several sectors in 2020 compared with recent years when defaults were relatively muted outside of energy and natural resources and consumer services. All sectors had elevated negative biases entering third-quarter 2020, reflecting broad credit deterioration. The consumer/service sector leads all sectors with 29 defaults, followed by energy and natural resources with 18, leisure time/media with 11, aerospace/automotive/capital goods/metal with nine, and health care/chemicals with seven.

Chart 5


The turn in the business cycle was probably sharpest for companies in the leisure time/media and consumer/service sectors. Revenue will likely remain weak even after states broadly reopen and traffic patterns begin rebounding. We don't expect sales for many issuers in retail to return to 2019 levels until 2022, with risk tilted to the downside. Leisure companies likely face the same difficult reality. The proportion of issuers in each sector rated 'B-' or lower reached all-time highs in second-quarter 2020, with leisure time/media at 41.5% and consumer/service at 38.5% in June. More defaults are likely, especially if the economic recovery is slower than anticipated.

In the energy and natural resources sector, oil and gas producers have little flexibility to repair margins through additional efficiency gains or asset sales, and speculative-grade oil and gas issuers have had difficulty accessing capital markets. The proportion of issuers in the sector rated 'B-' or lower spiked higher in March and was at 30.2% at the end of the second quarter, just one-and-a-half percentage points below the record high in third-quarter 2016. We expect to see more distressed exchanges and bankruptcies in the next year.

Many issuers in the aerospace/automotive/capital goods/metal (AACGM) sector entered the recession in a weakened state. For many of them, the U.S.-China trade war either depressed margins with tariffs, hurt demand due to lower business fixed investment--or both. The proportion of issuers in the sector rated 'B-' or lower reached an all-time high in June of 29.9%. Most defaults in the AACGM sector through the second quarter have come from issuers in the capital goods sector, and we anticipate more in the next year.

However, the auto sector within AACGM also appears strained. By the end of second-quarter 2020, over one-third of issuers in that sector were rated 'B-' or lower and its negative bias had jumped 37 percentage points in just three months to 83%. In June, S&P Global Ratings revised its estimate for light vehicle sales in 2020 lower to 12.7 million units, a 25% drop from 2019, and even with a recovery, sales are expected to remain 10%-15% below 2019 levels in 2021. The credit deterioration of speculative-grade auto suppliers is most notable in the sector. It's imperative that these weaker-rated issuers shore up liquidity as they prepare to restart production.

Like the rest of the service economy, health care companies were forced to close or curtail operations once stay-at-home orders were put in place. Challenges will remain even after the recovery begins, with elevated unemployment leading to higher uncompensated care, lower service volumes, and a shift in payer mix toward less-profitable government sources. The proportion of issuers in the health care/chemicals sector rated 'B-' or lower reached a record high in May, and just below that level at 33.8% at the end of second-quarter 2020. More defaults in the sector may be ahead for highly leveraged speculative-grade issuers, especially those that depend on patient volumes.

Optimistic Scenario: Markets Suggest A Decline In Defaults

Offsetting the rapid deterioration in credit metrics since March, fixed-income markets are still quite supportive of speculative-grade entities and have been extending credit at a pace consistent with 2019 (see chart 6). Bond and leveraged loan issuance fell off in July after a particularly strong June. Total issuance for speculative-grade bonds and leveraged loans together has reached $423.2 billion through July, down 1.5% from the same point in 2019.

Chart 6


Alongside heady bond issuance totals this year, corporate spreads have continued to fall since the Fed introduced its liquidity facilities in March.  The relative risk of holding corporate bonds can be a major contributor to future defaults because of the marginal pressure on cash flow when an issuer needs to refinance maturing debt. The U.S. speculative-grade corporate spread provides an indication of future defaults based on a roughly one-year lead time because it reflects near-term expectations of issuer credit risk (see chart 7). At the current level, the speculative-grade bond spread implies a default rate by June 2021 that's in line with our optimistic forecast.

Chart 7


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 aside from downturns. But even under more-placid conditions, there has never been a 12-month period with no defaults in the U.S. With this in mind, we believe the corporate distress ratio is a more-targeted indicator of future defaults across all points in the credit and economic cycles (see chart 8).

Chart 8


The distress ratio 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. (The distress ratio is the number of distressed credits or speculative-grade issues with option-adjusted composite spreads of more than 1,000 basis points [bps] relative to U.S. Treasuries divided by the total number of speculative-grade issues.) 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 12.7% in June corresponds to a roughly 3.4% default rate for March 2021. This is far below even our optimistic forecast.

The Situation Is Improving, But Markets May Still Be Overly Optimistic

Investors are more optimistic than the underlying economy and financial markets suggest. Using a model based on the VIX, the M1 money supply, and the Purchasing Managers' Index (PMI), the speculative-grade bond spread in the U.S. at the end of July was about 183 bps below our estimate (see chart 9). In February, the gap was more than double the previous record high, reaching 392 bps before shrinking to 325 bps in May. This wide gap is evidence that optimism around struggling businesses and the trajectory of the U.S. economy is the consensus among market participants.

This raises the question whether the market is dislocated. With the money supply unlikely to shrink anytime soon and the PMI already having recovered to 54.2 in July, the model suggests this depends on the level of uncertainty that persists. If the certain path forward is a short bridge back to prospering businesses and balanced economic risks, the market wouldn't appear to be dislocated. But our economists have called attention to recent real-time measures of economic activity that suggest the third-quarter rebound may be more muted than initially expected.

Chart 9


Just as the nature of the stress caused by the coronavirus is unusual and difficult to predict, so too are the potential upsides to the current situation. Markets have reacted positively to the Fed facilities and fiscal assistance programs, and second-quarter earnings--though sharply negative--are coming in better than expected. Given the underlying medical nature of this particular economic downturn and potential reversal, positive developments will not show up in traditional economic data such as the PMI, but only indirectly through financial market optimism.

Pessimistic Scenario: Second Wave Would Starve More Companies Of Cash For Longer

In our pessimistic scenario, we anticipate the default rate could reach a historic high. For now, we believe it could reach 15.5% (284 defaults) by June 2021. We factor in a number of negative outcomes as a result of a resumption of the virus and an increased caseload later in the year or in early 2021. Consumer spending would contract once again as social distancing measures resume or amplify. Unemployment would likely also rise, and GDP would end up lower than the baseline assumption and take longer to rebound.

All of this would put greater stress on cash flow and require companies 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. The Fed would almost certainly be expected to provide more market liquidity, but considering the positive impact so far has been indirect for the speculative-grade segment, any future benefit from the monetary side may be muted for weaker issuers. In this scenario, we expect historical default rates for 'B-' and 'CCC/C' rated issuers to grow to new highs.

Unprecedented Times Cloud The Future

Because of the wide range of possibilities, it's perhaps more appropriate to think of these as separate possible outcomes rather than simply a range. Given the unprecedented nature of the pandemic, resulting containment measures, fiscal and monetary responses so far, and the uncertain path for all of these factors, it's also possible that, regardless of which of these three outcomes is more accurate, defaults could follow a path resembling an elevated plateau, or subsequent "waves" of heightened defaults, or even a decline consistent with our optimistic scenario, as opposed to the historical peak-and-trough cycles of the past (see chart 10).

Chart 10


So far, primary debt markets remain largely liquid while revenues in many sectors are flagging.  This is creating a situation for markedly higher debt to EBITDA and overall debt levels for many companies, and the speculative-grade entities in the U.S. were already coming into 2020 with a historically high proportion of weaker ratings after years of increased leverage. If companies are to remain solvent in the future, these higher debt burdens 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 our economists' base case, this latter alternative is unlikely, given the expectation for a drawn-out economic recovery.

How We Determine Our U.S. Default Rate Forecast

Our U.S. default rate forecast is based on current observations and 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 4% in June 2021 (74 defaults in the trailing 12 months) in our optimistic scenario and 15.5% (284 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 issuer base.  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.

Related Research

This report does not constitute a rating action.

Ratings Performance Analytics:Nick W Kraemer, FRM, New York (1) 212-438-1698;
Jon Palmer, CFA, New York;
Kirsten R Mccabe, New York + 1 (212) 438 3196;
Research Assistant:Lyndon Fernandes, Mumbai

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