- We expect the U.S. trailing-12-month speculative-grade corporate default rate to rise to 9% by September 2021 from 6.3% in September 2020. To reach this baseline forecast, 165 speculative-grade companies would need to default.
- In our optimistic scenario, we expect the default rate to fall to 3.5% by September 2021 (64 defaults), and in our pessimistic scenario, we expect the default rate to expand to 12% (220 defaults).
- Credit stress has receded since the second quarter, but a second wave of COVID-19 infections and further economic restrictions remain risks.
- Market expectations still imply a much lower default rate than either economic or credit indicators--a divergence that has persisted through most of the pandemic.
S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to increase to 9% by September 2021 from 6.3% as of September 2020 (see chart 1). After a stronger-than-expected pace of growth in the third quarter, S&P Global economists expect U.S. economic momentum to weaken in the fourth quarter but recover to a firmer growth trajectory in 2021. Credit stress, marked by high downgrades and record-high negative bias (the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications), has subsided considerably since peaking in April, and markets have been receptive to new debt issuance at all levels of credit quality. In part, the recent boom in funding has enabled speculative-grade (rated 'BB+' or lower) firms to significantly reduce their upcoming maturities in 2021.
In our pessimistic scenario, we forecast the default rate will rise to 12%. In this scenario, we anticipate a slower pace of economic growth, making the recovery both longer and lower than S&P Global economists' base case. A protracted resumption of COVID-19 cases and longer lockdowns would put higher stress on many leveraged firms and households. Given the national caseload has already increased in the past few weeks, the ability of the country to halt this increase and effectively cope with those hospitalized will be imperative. The extent of lockdowns, particularly during the fourth quarter, which is typically a period of increased consumer spending (due to the holidays), will also be a major factor in the ultimate economic hit. Furthermore, should the U.S. end up with a split government, this could raise the prospects of a reduced fiscal assistance package.
In our optimistic scenario, we forecast the default rate will fall to 3.5%. As in recent quarters, this scenario largely reflects what market signals are implying about future default activity. Compared with our base-case assumptions, fixed-income markets remain optimistic, given current risk pricing even among the weakest issuers. This optimism is likely resulting from faith that many of the Federal Reserve's current policies have provided a stable tailwind, encouraging news regarding vaccine development and treatment research, and perhaps the belief that should the economy face continued stress from new waves of infection, the government and the Fed will once again provide support, where possible.
Our current forecast does not incorporate any assumptions regarding the impact of the expiring Federal Reserve liquidity facilities at year-end. We feel these programs have had a positive impact on credit market sentiment this year and will be closely monitoring their closure and any noticeable market reactions in the coming weeks.
Credit Deterioration Turns A Corner
The first half of 2020 showed some of the highest downgrade rates on record among speculative-grade companies in the U.S., particularly at the lower rungs of speculative-grade ratings. This caused a sharp rise in the percentages of issuers rated 'B-' and 'CCC'/'C', which both hit all-time highs in the second quarter.
However, after May, the pace of downgrades quickly returned to pre-COVID-19 levels, and even the trailing-12-month downgrade rate of the 'B' category was less than 2% in September after hitting 7.8% in June. Meanwhile, the 'CCC'/'C' upgrade rate ticked up to 2.7%, the highest reading since June 2019. Despite this positive turnaround in rating actions, the proportion of issuers with particularly weak ratings remains elevated (see chart 2).
With defaults racking up and the pace of downgrades subsiding, the ranks of the lowest ratings started to pull back in the third quarter. That said, the proportion of speculative-grade issuers at 'CCC'/'C' remains historically high, supporting a higher default rate in the next 12 months.
Within the speculative-grade segment, most sectors are likely to see further downgrades over the next 12 months, and typically downgrade momentum precedes defaults. Some sectors in the 12 months ended with the third quarter experienced net downgrade rates (upgrade rates minus downgrade rates) of 30% or more, with most of these also showing a net negative bias (positive bias minus negative bias) in excess of 50% (see chart 3). Both of these measures imply particularly harsh conditions for creditworthiness. This is most obvious in sectors under the greatest stress as a result of the virus and collapsing oil prices, such as leisure time/media, transportation, and energy and natural resources.
Despite continued stress in certain sectors, the overall speculative-grade net downgrade rate slightly declined to -23% through September. The net bias rose to -41% in September as the negative bias for all speculative-grade companies fell to 47.5% from 52.4% in June. The negative bias fell further in October, to 45.1%, its lowest level since March.
These rating action trends indicate credit deterioration peaked in the second quarter (see chart 4). Downgrades slowed and the proportion of speculative-grade issuers on CreditWatch with negative implications fell by half in the third quarter. Through October, the speculative-grade net negative bias was still high, at 40%, but down from the all-time high of 50% in July.
For comparison, in the 2008-2009 financial crisis, peak credit deterioration occurred in the first quarter of 2009. It was roughly three quarters later when the default rate reached its peak during that cycle. If this pattern holds for the most recent recession, a peak default rate would arrive in the first quarter of 2021.
Default Signposts Show Improvement
Measures of economic and financial conditions continued to improve in the third quarter (see table). However, market volatility returned in October, with the VIX spiking to 38 at month-end. The Fed survey on lending conditions reached the highest reading since 2008, but it reflected activity during the second quarter, around the time that credit deterioration peaked. While we saw continued improvement in most economic and financial data during the second and third quarters, further improvement will likely come more slowly, and risk remains to the downside.
|U.S. Warning Signals Of Default Pressure|
|U.S. unemployment rate (%)||7.9||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||71.2||41.5||0.0||5.4||(2.8)||(4.2)||2.8||(15.9)||(15.9)||(11.3)||(10.0)|
|Industrial production (% chya)||(7.3)||(10.7)||(4.7)||(0.8)||(0.2)||1.0||2.3||3.8||5.4||3.4||3.8|
|Slope of the yield curve (10-year less 3-month, bps)||59.0||50.0||59.0||37.0||(20.0)||(12.0)||1.0||24.0||86.0||92.0||101.0|
|Corporate profits (nonfinancial, % chya)||(14.5)||(18.8)||(5.7)||1.3||(0.3)||0.5||(3.3)||5.8||8.6||9.2||11.4|
|Equity market volatility (VIX)||26.4||30.4||53.5||13.8||16.2||15.1||13.7||25.4||12.1||16.1||20.0|
|High-yield spreads (bps)||576.9||635.9||850.2||399.7||434.1||415.6||385.2||481.9||300.6||332.3||330.2|
|Interest burden (%)||8.6||7.9||7.5||7.7||7.7||7.9||7.7||8.0||8.6||9.4|
|S&P Global Ratings distress ratio (%)||9.5||12.7||35.2||7.5||7.6||6.8||7.0||8.7||5.7||5.1||5.4|
|S&P Global Ratings U.S. speculative-grade negative bias (%)||47.5||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 (%)*||70.4||95.2||90.4||82.9||82.9||69.6||76.0||69.0||52.8||62.2||54.3|
|Proportion of spec-grade initial issuer ratings 'B-' or lower (%)||44.8||70.7||55.6||40.4||38.2||41.9||38.3||32.8||29.0||31.8||34.0|
|U.S. weakest links (count)||391||431||319||196||179||168||151||145||145||144||138|
|Notes: Fed survey refers to net tightening for large firms. S&P Global Ratings' outlook distribution defined as ratio of firms with negative bias compared with firms with positive bias. *For speculative-grade entities only; excludes movement to default. Chya--Change from a year ago. Bps--Basis points. Sources: Global Insight and S&P Global Ratings Research.|
Defaults Are Now At Their Highest Since 2009
The total number of U.S. corporate defaults this year reached 120 through the end of the third quarter, surpassing the post-Great Financial Crisis high seen in 2016 (106). Nearly all sectors had elevated negative biases entering fourth-quarter 2020, reflecting the broad credit deterioration stemming from the pandemic. Through the third quarter, the consumer/service, energy and natural resources, and leisure time/media sectors tallied the most issuer defaults, with 40, 32, and 16, respectively (see chart 5).
In the consumer/service sector, negative rating actions have been concentrated among durable goods, apparel, cosmetics, dine-in restaurants, department stores, and issuers with specialty offerings. As states broadly reopen and traffic patterns begin to rebound, S&P Global Ratings expects sales for many of these issuers won't return to 2019 levels until 2022. However, one exception among nonessential retail and consumer products has been issuers offering home-related goods, which we now believe are well positioned for the next 12-18 months. There are signs that credit deterioration might have peaked, but with nearly two-fifths of all rated issuers in the consumer/service sector rated 'B-' or lower, more defaults are likely over the next year amid challenging operating and tighter financing conditions for the weakest-rated issuers.
Most rating actions in the energy and natural resources sector have been among speculative-grade issuers due to difficulties in accessing capital markets. S&P Global Ratings recently revised its West Texas Intermediate oil price assumption for the remainder of 2020 to $35 per barrel from $25 and cut its assumption for 2022 to $45 from $50 (leaving 2021 unchanged at $45). The change in assumptions supports credit quality in the near term. However, with U.S. shale average break-even prices near $50, weaker-rated issuers, particularly those with large exposure to oil, remain vulnerable to downward rating actions. With nearly one-third of all rated issuers in the sector rated 'B-' or lower, more distressed exchanges and bankruptcies are likely over the next year.
Most rating actions in the leisure time/media sector have been concentrated among travel-related issuers, local media, live events companies, and movie exhibitors. We don't expect a recovery for out-of-home entertainment in the near term, given consumers might not return to venues until a vaccine is widely available. Even when credit metrics do recover, issuers may remain at risk to negative rating actions because of secular changes that accelerated or developed during the pandemic. With two-fifths of all rated companies in the sector rated 'B-' or lower, more defaults are likely over the next year, especially if the economic recovery slows.
Markets Point To A Decline In Defaults
The surge in bond issuance following the April 9 announcement that the Fed would expand its credit facilities to support fallen angel debt (debt downgraded to speculative grade from investment grade) and high-yield bond exchange-traded funds provided much-needed liquidity to companies operating under extreme uncertainty. Liquidity has been available across the spectrum, with strong issuance in every rating category. As long as liquidity remains available, the fallout from the pandemic may stay relatively contained. Through September, combined speculative-grade bond and leveraged loan issuance reached $572.6 billion, up from $543.4 billion at the same time in 2019 (see chart 6).
However, weaker-rated companies in the hardest-hit sectors remain vulnerable to liquidity risks, and the pandemic has accelerated secular changes within several sectors that have impaired business models. The extraordinary monetary and fiscal policy responses to the pandemic will likely allow some weaker-rated issuers to avoid default but should only delay default for others.
Much of this recent issuance has helped to greatly reduce upcoming maturities. As of Oct. 1, only $16.1 billion in outstanding debt was due in the fourth quarter of 2020, and another $149 billion was due in 2021 (see chart 7). These are small amounts compared with recent issuance totals, indicating any refinancing risk for the year ahead is also quite small. Moreover, roughly half of the speculative-grade debt due in 2021 is within the 'BB' category, which we expect to see muted default activity, if any.
Alongside the 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 indicates future defaults based on a roughly one-year lead time (see chart 8). At the current level, the speculative-grade bond spread implies a default rate in line with our optimistic forecast by September 2021.
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 outside of downturns. However, even in 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 9).
The distress ratio (defined as the number of distressed credits, or speculative-grade issues with option-adjusted composite spreads of more than 1,000 basis points relative to U.S. Treasuries, divided by the total number of speculative-grade issues) 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. 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 9.5% distress ratio in September corresponds to a roughly 2.9% default rate for June 2021. This is far below even our optimistic forecast.
Optimism Is Nearly Fully Priced In
Fixed-income investors are more optimistic about speculative-grade debt than near-term financial and economic indicators would imply. Using a model based on the VIX, the M1 money supply, and the Purchasing Managers' Index, we estimate that at the end of September, the speculative-grade bond spread in the U.S. was about 96 basis points (bps) below the model-implied level (see chart 10).
The gap has tightened since the all-time high of near 400 bps in February, though it then expanded again, and perhaps tellingly, the estimated spread and actual moved in opposite directions in October. However, the estimated spread's increase in October resulted entirely from the late October spike in the VIX, which has since returned to September levels.
Nonetheless, this persistent gap through the pandemic is likely the result of optimism around struggling businesses and the trajectory of the U.S. economy. It remains to be seen whether any setbacks to the optimistic case cause participants to reprice risky credit or instead accept a longer time horizon for the recovery. However, market participants have looked beyond near-term uncertainty throughout this downturn.
Just as the nature of the stress caused by the pandemic is unusual and difficult to predict, so too are the potential upsides. Markets have reacted positively to the Fed facilities and fiscal assistance programs thus far, and third-quarter earnings--though negative--rebounded from the second quarter. Given the unpredictability of this particular economic downturn, positive developments will not show up in traditional economic data such as the Purchasing Managers' Index, but only indirectly through financial market optimism.
Pessimistic Scenario: A Second Wave Could Starve More Companies Of Cash For Longer
In our pessimistic scenario, we anticipate the default rate could reach roughly its historical cyclical peak. For now, we believe it could reach 12% (220 defaults) by September 2021. We factor in a number of negative outcomes as a result of a resumption of the virus toward the end of the year or in early 2021. Consumer spending would contract once again as social distancing measures resume or amplify. Unemployment could stay elevated, 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 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. The Fed would almost certainly be expected to provide more market liquidity, but considering the positive impact thus 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 particularly for 'CCC'/'C' rated companies to rise toward historical highs.
Unprecedented Times Could Produce Unusual Results
Because of the many possibilities, it is perhaps more appropriate to think of these default forecasts as separate possible outcomes rather than simply a range. Given the 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 or waves of heightened defaults, as opposed to the peak-and-trough cycles of the past (see chart 11).
Thus far, primary debt markets remain largely liquid, but revenue in many sectors is flagging. This is laying the groundwork for markedly higher debt to EBITDA and overall debt levels for many firms, after the speculative-grade segment in the U.S. entered 2020 with an already historically high proportion of weaker ratings after years of increased leverage.
If firms are to remain solvent in the years ahead, they will either have to finance these higher debt burdens through even more debt or they will require organic revenue to grow at a faster pace than in the past. In S&P Global economists' base case, the latter 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 on 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 3.5% in September 2021 (64 defaults in the trailing 12 months) in our optimistic scenario and 12% (220 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).
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.
S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least one experimental vaccine is highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use 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.
- U.S. Corporate Downgrades Fell To Pre-Pandemic Levels In The Third Quarter, Oct. 14, 2020
- One-Third Of U.S. Distressed Issuers Have Faced Downgrades Or Default Since March, Oct. 8, 2020
- Economic Research: The U.S. Economy Reboots, With Obstacles Ahead, Sept. 24, 2020
- Global Refinancing--Rated Corporate Debt Due Through 2025 Nears $12 Trillion, July 27, 2020
- 2019 Annual Global Corporate Default And Rating Transition Study, April 29, 2020
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 Contributor:||Shripati Pranshu, CRISIL Global Analytical Center, an S&P affiliate, Mumbai|
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