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Default, Transition, and Recovery: The S&P/LSTA Leveraged Loan Index Default Rate Is Expected To Reach 8% By June 2021

Chart 1

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S&P Global Ratings Research expects the S&P/LSTA Leveraged Loan Index lagging twelve-month default rate (by number of issuers) to increase to 8% by June 2021 from 4.6% as of September 2020 (see chart 1). In this base-case scenario, about 85 issuers default in the index over the 12-month period that began July 1, 2020. Measures taken to slow the spread of COVID-19 and acute stress in the oil and gas sector from the recent collapse in prices have contributed to an uptick in defaults and a historically high number of downgrades through second-quarter 2020. S&P Global economists expect the recovery in the U.S. to be a prolonged process, with GDP expected to grow 3.9% in 2021 after contracting 4% this year (see "The U.S. Economy Reboots, With Obstacles Ahead," Sept. 24, 2020). Continued waves of new infections, no widely available vaccine, no new fiscal stimulus, and rising trade tensions with China present downside risks to this outlook. This backdrop will continue to strain already highly levered firms with reduced revenues, pushing firms closer to insolvency, particularly speculative-grade (rated 'BB+' or lower) companies in the most affected sectors.

In our optimistic scenario, the default rate will fall to 2.5% through June 2021. In this scenario, about 29 issuers default over the 12-month period that began July 1, 2020. Our optimistic forecast rests on expectations roughly in line with those implied by credit markets. A combination of factors have contributed to market optimism, including a swift initial response from monetary and fiscal authorities, encouraging news around vaccines and treatments, and--despite challenges--generally stronger economic performance than initially expected. However, foremost among reasons for market optimism is confidence that the Fed is both ready and capable of doing what's necessary to keep financing conditions loose.

In our pessimistic scenario, the default rate will rise well above the all-time high to 9.5% by June 2021. In this scenario, about 103 issuers default over the 12-month period that began July 1, 2020, as consumer spending remains suppressed into the fourth quarter, and the unemployment rate remains elevated through 2021. Sluggish economic activity that persists beyond second-quarter 2020 will perpetuate a cycle of a weak labor market and damaged consumer confidence leading to weak business revenues that will eventually subject issuers with the least liquidity and most leverage to the willingness of the market to lend. As waves of new cases in the U.S. continue the likelihood of our pessimistic scenario increases. Even if overall financing conditions remain loose as the recession drags on in this scenario, the market won't be indiscriminate.

Unprecedented Number Of Downgrades In Second-Quarter Of 2020

Credit deterioration across S&P/LSTA Leverage Loan Index industries was swift and significant into the third quarter of 2020. Issuers most exposed to risks demonstrated by both COVID-19 and the collapse in oil prices have witnessed an unprecedented rise in downgrades, a leading indicator of default. At the end of 2019, proportion of issuers within the S&P/LSTA Leverage Loan Index rated 'CCC+' or lower was just 8%, increasing to 14% by the third quarter of 2020 (see chart 2). The count of loan facility downgrades has ebbed since peaking in the months of March through June; however, uncertainty surrounding the full extent of COVID-19 on the economy leaves room for further deterioration.

Chart 2

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It's no surprise the proportion of issuers rated 'CCC+' and lower in industries most vulnerable to lockdowns and social distancing has moved in lock step with an increase in downgrades. Downgrade severity year to date has been most prominent in leisure, accounting for 11% of total downgrades. Industry-specific risk in light of COVID-19 and stress in the oil and gas sector has also led to elevated downgrades in business and equipment services (10% of downgrades), electronics (7%), oil and gas (6%), and retailers (other than food/drug) (6%).

Notably, the concentration of retailers (other than food/drug) rated 'CCC+' and lower declined from the beginning of the year. This industry has tallied the third most issuer defaults year to date, all from ratings of 'CCC+' and lower, which partially explains this. However, this may be an indication that credit deterioration has peaked for parts of the industry.

Taking a slightly broader view of vulnerable credits, the three largest industries by issuer count in the S&P/LSTA Leverage Loan Index have higher concentrations of ratings 'B-' or lower since the year began (see chart 3). Through September, electronics/electric, business equipment and services, and health care have each seen the proportion of ratings 'B-' or lower rise to 59%, 48%, and 43%, respectively, from 51%, 39%, and 35% at the beginning of the year.

Chart 3

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More Defaults Expected Across Several Industries

The unprecedented number of S&P/LSTA Leverage Loan Index issuer downgrades in the first half of 2020 and high proportion of index issuers rated 'B-' or lower indicate heightened credit stress, which often precedes an increase in defaults. The industries with higher issuer representation in the S&P/LSTA Leveraged Loan Index that were most affected by the sudden reduction in business and consumer spending will likely lead the default tally among index issuers over the next 12 months.

Chart 4

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The shock to the business cycle was probably sharpest for leisure, retail, and food service companies. These three industries combined account for the most S&P/LSTA Leverage Loan Index issuer defaults year-to-date with 16. While consumer products issuers have faced similar pressure, they account for just two defaults in the index year to date. The distressed ratio for these industries has fallen considerably as a result of monetary and fiscal policy responses to the pandemic that bolstered consumer spending and reignited primary market activity, allowing most issuers in need of liquidity across all industries to raise capital.

Two of the most notable improvements through the beginning stages of the economic recovery among industries represented in the S&P/LSTA Leverage Loan Index have come from retailers (other than food/drug) and clothing/textiles. Both industries have seen their distressed ratios fall nearly 70 percentage points, and now neither appears elevated. Similarly, aerospace and defense has seen its distressed ratio fall over 65 percentage points from its peak, and air transport, while still elevated, has seen its distressed ratio fall over 80 percentage points despite the long-term challenges both industries face.

For many retail and food service issuers, S&P Global Ratings doesn't expect sales to return to 2019 levels until 2022, and risks remain to the downside. Discretionary consumer products issuers, like those in the cosmetics/toiletries industry, face a similar outlook. A recovery for leisure issuers isn't expected in the near-term either, as consumers may not return to venues until a vaccine is widely available, and many issuers may remain vulnerable because of secular changes that accelerated or developed during the pandemic. Market confidence in monetary and fiscal authorities to backstop economic and credit risks has participants looking through these fundamental issues. However, we expect more issuer defaults among S&P/LSTA Leverage Loan Index issuers in these industries, especially if the economic recovery slows.

While still elevated, the S&P/LSTA Leverage Loan Index oil and gas industry distressed ratio has come down nearly 60 percentage points from its peak. With the improved backdrop, S&P Global Ratings revised its oil and natural gas price assumptions--a positive for oil and gas issuer credit quality in the near-term. However, U.S. shale average breakeven prices remain near $50, and weaker rated issuers, particularly those with large exposure to oil, remain vulnerable. With nine issuer defaults year to date in the index, oil and gas leads all industries represented in the index in both the number of defaults and defaulted amount. We expect more defaults among S&P/LSTA Leverage Loan Index oil and gas issuers over the next year.

The S&P/LSTA Leverage Loan Index business equipment and services industry falls under services and leasing, which includes companies that derive revenues from various sectors. The services and leasing industry accounts for the second most defaults in the index year to date with seven. The largest include Hertz (vehicle rental and leasing services) and Constellis Holdings (defense and security services). We expect more defaults among lower rated S&P/LSTA Leverage Loan Index business equipment and services issuers that have operations linked to sectors most affected by reduced spending.

There have been three health care issuer defaults in the S&P/LSTA Leverage Loan Index year to date, and more are possible among highly leveraged speculative-grade issuers, especially those that depend on patient volumes. S&P Global Ratings expects challenges for health care companies to remain 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.

There have been two automotive issuer defaults in the S&P/LSTA Leverage Loan Index year to date and more are possible. We expect issuers in the automotive industry to take a big hit to revenue in 2020 as S&P Global Ratings currently forecasts U.S. light vehicle sales will decline 21% year over year to 13.3 million units. Given recent trends, there is some modest upside to the base case. However, amid questions about the sustainability of recent demand, we expect sales to remain relatively depressed through 2022. Speculative-grade auto suppliers have experienced the most credit deterioration during the downturn.

Two of the largest S&P/LSTA Leverage Loan Index issuer defaults in 2020 were from issuers in the telecommunications industry. S&P Global Ratings expects issuers that derive sales from small and midsize businesses (SMBs) and enterprise customers to remain under pressure as many have reduced operations or have closed permanently. There have been four telecommunications issuer defaults in the index year to date. A slower-than-expected recovery would further pressure revenue and could lead to more defaults among telecommunications industry issuers in the index.

Chart 5

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Differences In Default Rate Measurement

The definition of default for each default rate series is slightly different. The S&P Global Ratings definition of default determines the U.S. trailing-12-month speculative-grade corporate default rate. S&P Global Market Intelligence's Leveraged Commentary & Data (LCD) definition of default determines the S&P/LSTA Leveraged Loan Index lagging twelve-month default rate by number of issuers. The differences between each definition are the primary drivers of the variation between each series.

Summary Of Differences In Default Definitions

S&P Global Ratings Definition

S&P Global Ratings deems 'D' and 'SD' ratings to be defaults for the purposes of its default studies. An issuer rated 'SD' or 'D' is in default on one or more of its financial obligations, including rated and unrated financial obligations but excluding hybrid instruments classified as regulatory capital or in nonpayment according to terms.

An issuer is considered in default unless S&P Global Ratings believes payments will be made within five business days of the due date in the absence of a stated grace period, or within the earlier of the stated grace period or 30 calendar days. A 'D' rating is assigned if the default is expected to be a general default and that the issuer will fail to pay all or substantially all of its obligations as they come due. An 'SD' rating is assigned if the issuer has selectively defaulted on a specific issue or class of obligations but will continue to meet its payment obligations on other issues or classes of obligations in a timely manner.

S&P Global Ratings will either lower the issuer rating to 'D' or 'SD' if it conducts a distressed debt exchange offer. S&P Global Ratings considers debt exchange offers tantamount to default when they meet two conditions: if they're distressed rather than purely opportunistic and if the investor will clearly receive less value than the promise of the original securities.

S&P/LSTA Index Definition

S&P Global Market Intelligence's LCD definition of default only includes defaults on loan instruments and does not include distressed debt exchanges. For an issuer default to be counted under the LCD definition, the issuer either filed for bankruptcy, S&P Global Ratings downgraded it to 'D', or it missed a principal/interest payment on a loan without forbearance. Importantly, not all firms we rate speculative-grade are included in the S&P/LSTA Index. For an issuer to be included, it must have issued a U.S. dollar-denominated, senior secured, syndicated term loan instrument with a minimum term of one year at inception, a minimum initial spread of LIBOR+125, and a minimum initial size of $50 million. Loans are retired from the index when no bid is posted on the facility for at least 12 successive weeks or when the loan is paid out or paid down to a negligible amount.

Chart 6

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How We Determine Our Default Rate Forecasts

The S&P/LSTA Leveraged Loan Index default rate forecasts are based on recent observations and expectations around the path of the U.S. economy and financial markets. Included among various factors we consider is our proprietary default rate model for the S&P/LSTA Leveraged Loan Index issuer base. The main components of the model are the U.S. trialing-12-month speculative-grade corporate default rate, a leveraged loan debt-to-EBITDA ratio, the ratio of selective defaults to total defaults, changes to the ratings mix of loans, the S&P/LSTA Leveraged Loan Index distressed ratio, and the unemployment rate. The model data sources include S&P Global Market Intelligence's LCD, S&P Global Market Intelligence, S&P Global Ratings Research, Oxford Economics, Bureau of Labor Statistics, and Haver Analytics.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

We would like to thank our colleagues in Methodologies and S&P Global Market Intelligence's Leveraged Commentary & Data (LCD) for their assistance with this report.

Related Research

This report does not constitute a rating action.

Ratings Performance Analytics:Nick W Kraemer, FRM, New York (1) 212-438-1698;
nick.kraemer@spglobal.com
Jon Palmer, CFA, New York;
jon.palmer@spglobal.com
Kirsten R Mccabe, New York + 1 (212) 438 3196;
kirsten.mccabe@spglobal.com

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