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Default, Transition, and Recovery: The S&P/LSTA Leveraged Loan Index Default Rate Is Expected To Reach 6.5% By September 2021

COMMENTS

Credit Trends: U.S. Corporate Rating Actions Show Post-COVID-19 Credit Recovery Has Begun

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Default, Transition, and Recovery: The S&P/LSTA Leveraged Loan Index Default Rate Is Expected To Reach 6.5% By September 2021

Chart 1

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S&P Global Ratings Research expects the S&P/LSTA Leveraged Loan Index lagging 12-month default rate (by number of issuers) to reach 6.5% by September 2021 from 4.5% as of October 2020 (see chart 1).   In this base-case scenario, about 71 issuers default in the index over the 12 months that began Oct. 1, 2020. S&P Global economists expect the recovery in the U.S. to be a prolonged process, with GDP growing 4.2% in 2021 after contracting 3.9% this year (see "Staying Home For The Holidays," Dec. 2, 2020). Downside risks to our baseline forecast include continued waves of new infections, no widely available vaccine, no new fiscal stimulus, and rising trade tensions with China. This backdrop may continue to strain already highly leveraged 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 September 2021.   In this scenario, about 29 issuers default over the 12 months that began Oct. 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. Most recently, announcements of promising clinical trial results for several vaccine candidates have further bolstered the optimistic view, with a possibility that initial doses of a vaccine will be available in the U.S. as early as December 2020. As communities across the U.S. face their greatest risk from COVID-19 since April, and though challenges still must be overcome before a majority of the U.S. population can be vaccinated in 2021, market optimism remains resilient.

In our pessimistic scenario, the default rate will reach 8% by September 2021.   In this scenario, about 85 issuers default over the 12 months that began Oct. 1, 2020. As consumer spending plunges and the unemployment rate spikes higher, sluggish economic activity would continue into 2021, leading to weak business revenues that eventually subject issuers with the least liquidity and the most leverage to the willingness of the market to lend. Even if overall financing conditions remain loose during another economic downturn, the market won't be indiscriminate.

Issuer Downgrades Have Eased

Credit deterioration across S&P/LSTA Leverage Loan Index industries was swift and significant in the first half of 2020. There was an unprecedented rise in issuer downgrades, a leading indicator of default, which began in March amid risks brought on by both COVID-19 and the collapse in oil prices. Since then, rating actions have stabilized, a positive signal that may indicate credit deterioration has peaked.

Chart 2

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However, the proportion of issuers in the S&P/LSTA Leverage Loan Index rated in the riskiest categories remains alarmingly high. Entering the year, the proportion of issuers rated 'B-' or lower was 32.2%, already near levels in 2009 amid the global recession. After the wave of downgrades in the second quarter, that proportion jumped to 44% and was just below that entering December at 43.3%. The slowing pace of issuer downgrades since the second quarter is a positive signal, but issuer credit quality remains very weak overall and the downside risks to the recovery leave room for further deterioration.

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 60%, 49%, 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 entertainment/leisure and retail/restaurant companies. Issuers operating in these categories combined account for the most S&P/LSTA Leverage Loan Index issuer defaults year to date with 16. While consumer product companies have faced similar pressure, they account for just three defaults in the index year to date.

After monetary and fiscal policy responses to the pandemic bolstered consumer spending and reignited primary market activity, the distressed ratios for these industries have fallen considerably as most issuers in need of liquidity have been able to raise capital. Distressed ratios, a leading indicator of default, signal the degree to which issuers are facing extraordinary stress. Among the most improved in the index, the retailers (other than food/drug) and clothing/textiles industries have seen their distressed ratios fall nearly 70 percentage points, and now neither appears elevated.

Through the beginning stages of the economic recovery, distressed ratios have notably improved in several of the industries within the S&P/LSTA Leverage Loan Index. The distressed ratio for aerospace and defense has fallen over 65 percentage points from its peak, and the ratio for air transport, while still elevated, has fallen nearly 90 percentage points despite the long-term challenges both industries face. Similarly, and perhaps the most surprising, the oil and gas distressed ratio has fallen over 70 percentage points from its peak.

While we've seen clear improvement in credit indicators, the outlook for the industries most affected by the recession remains negative in the near term. 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, but more issuer defaults are likely, especially if the economic recovery slows.

Prospects have marginally improved for oil and gas issuer credit quality in the near term as S&P Global Ratings recently revised its oil and natural gas price assumptions. 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.

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 12-month default rate by number of issuers. The differences between each definition are the primary drivers of the variation between each series.

Table 1

Summary Of Differences In Default Definitions
S&P Global Ratings definition S&P/LSTA Leveraged Loan Index definition
• Issuer files for bankuptcy (results in a 'D' rating) • Issuer files for bankruptcy
• Issuer missed principal/interest on a bond instrument (results in a 'D' or 'SD' rating)* • Issuer downgraded to 'D' by S&P Global Ratings
• Issuer missed principal/interest on a loan instrument (results in a 'D' or 'SD' rating)* • Issuer missed principal/interest on a loan instrument without forbearance
• Distressed Exchange (results in a 'D' or 'SD' rating) • The baseline September 2021 forecast for the S&P/LSTA Leveraged Loan Index lagging twelve-month default rate by number of issuers is 6.5%.
• The baseline September 2021 forecast for the U.S. trailing-12-month speculative-grade corporate default rate is 9%
*Under the S&P Global Ratings definition, 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.

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. Not all speculative-grade firms are included in the 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.

Table 2

Index Composition By Rating Category Compared To All Speculative-Grade Issuer Ratings
(%) All speculative-grade issuers* S&P/LSTA LL Index rated issuers¶
BB 26.5 18.5
B 58.5 66.8
CCC/C 15 14
'B-' and lower 39.4 43.3
*Data as of Oct. 31, 2020. ¶Data as of Nov. 30, 2020. The index includes some issuers rated in the 'BBB' category. Sources: S&P Global Market Intelligence's Leveraged Commentary & Data (LCD), S&P Global Market Intelligence's CreditPro®, and S&P Global Ratings Research.

Chart 5

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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. 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. trailing-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.

S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. While the early approval of a number of vaccines is a positive development, countries' approval of vaccines 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 mid-2021. 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.

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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