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Default, Transition, and Recovery: The U.S. Speculative-Grade Corporate Default Rate Could Reach 7% By December 2021


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Default, Transition, and Recovery: The U.S. Speculative-Grade Corporate Default Rate Could Reach 7% By December 2021


S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to increase to 7% by December 2021 from 6.6% as of December 2020 (see chart 1).  Economic growth is set to pick up this year, while the pace of corporate downgrades has slowed and our rating outlook and CreditWatch distributions have improved recently. Nonetheless, a large component of economic growth this year will be improvement over the very suppressed activity in 2020, and the speculative-grade ('BB+' or lower) rating distribution remains much weaker than at the start of last year. These factors lead to a base-case December 2021 default rate slightly above the year-end 2020 rate, but potentially following a higher default rate earlier this year. Credit stress remains elevated for many sectors with high proportions of 'CCC' to 'C' ratings, such as leisure, nonessential retail, and consumer products.

In our pessimistic scenario, we forecast the default rate will rise to 9.5%.  In this scenario, we account for two possibilities, the first being further waves of infection--which could lead to further economic lockdowns--or mutations of the virus that could be more contagious or severe. Second, the gradual unwinding of fiscal or monetary stimulus could leave the proportion of weaker-rated companies vulnerable to increased debt loads, particularly if interest rates rise and give better returns to less risky asset classes.

In our optimistic scenario, we forecast the default rate will fall to 3%.  This scenario largely reflects what market signals are implying about future default activity. Fixed-income markets remain optimistic, given current risk pricing even among the weakest issuers. This is despite the fact that many of the Federal Reserve's pandemic-response liquidity facilities have ended. Vaccine deployment has commenced. New rounds of fiscal stimulus are also expected to support economic growth this year, particularly in the near term.

Chart 1


Credit Deterioration Peaked In The Second Quarter

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 resulted in a sharp rise in the percentages of issuers rated 'B-' and 'CCC' to 'C', which both hit all-time highs in the second quarter.

However, in recent months, the pace of downgrades has subsided considerably, while defaults have picked up. This has prompted a drop in the proportion of these weakest ratings (see chart 2). Still, credit risk as exemplified by our ratings mix remains high.

Chart 2


Within the speculative-grade segment, most sectors still display the potential for further credit degradation. Some sectors in 2020 experienced net downgrade rates (upgrade rates minus downgrade rates) of 30% or more, with most of these also showing a negative net bias (positive bias, or the proportion of issuers with positive outlooks or ratings on CreditWatch with positive implications, minus negative bias) in excess of 40% (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 dipped to -21.6% through December. The net bias rose to -34% in December as the negative bias for all speculative-grade companies fell to 40.4%, from 47.5% in September. The negative bias fell further in January, to 38%, its lowest since March 2020.

Chart 3


These rating action trends indicate credit deterioration peaked in the second quarter (see chart 4). Downgrades slowed in the fourth quarter, and the proportion of speculative-grade issuers on CreditWatch with negative implications continued to fall. The speculative-grade net negative bias was still high at 34% in December, but it had improved during the quarter after peaking at an all-time high of 50% earlier in the year. Still, default risk remains elevated entering 2021.

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.

Chart 4


Sustained Improvement In Default Signposts

Measures of economic and financial conditions continued to improve in the fourth quarter (see table). The Fed survey on lending conditions, at 37.7, reflected tight lending standards during the third quarter, but the most recent survey, at 5.5, shows lending standards eased dramatically during the fourth quarter. Market volatility returned in January, with the VIX spiking higher to end the month at 33, but speculative-grade credit spreads have remained relatively stable at about 430 basis points (bps). Most economic and financial data has shown sustained improvement, but we expect further improvement to come more slowly, and some downside risk remains.

Indicators Of Credit Stress Continued To Improve In The Fourth Quarter
2020Q4 2020Q3 2020Q2 2020Q1 2019Q4 2019Q3 2019Q2 2019Q1 2018Q4 2018Q3 2018Q2 2018Q1
U.S. unemployment rate (%) 6.7 7.8 11.1 4.4 3.6 3.5 3.6 3.8 3.9 3.7 4.0 4.0
Fed Survey on Lending Conditions 37.7 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) (3.6) (6.3) (10.5) (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) 84 59 50 59 37 (20) (12) 1 24 86 92 101
Corporate profits (nonfinancial, % chya) 2.8 (18.8) (5.7) 1.3 (0.3) 0.5 (3.3) 5.8 8.6 9.2 11.4
Equity Market Volatility (VIX) 22.8 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) 434.4 576.9 635.9 850.2 399.7 434.1 415.6 385.2 481.9 300.6 332.3 330.2
Interest burden (%) 7.3 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 (%) 5.0 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 (%) 40.4 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 (%)* 56.5 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 (%) 57.3 44.8 71.7 54.7 39.6 38.2 40.5 39.6 32.8 29.7 31.8 34.0
U.S. weakest links (count) 338 391 430 316 195 178 167 150 144 144 143 137
Notes: Fed Survey refers to net tightening for large firms. S&P Global Ratings' outlook distribution defined as ratio of firms with negative bias to 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 Reach Their Highest Since 2009

There were 146 corporate issuer defaults in the U.S. during 2020, the highest number of defaults in a calendar year since 2009 (195). More than 60% of the companies that defaulted during the year were in either the consumer services or energy and natural resources sectors, which accounted for 47 and 42 defaults, respectively. The leisure time/media sector had the third-highest issuer default tally, with 17.

Although defaults were concentrated, credit deterioration stemming from the pandemic was broad. Nearly all sectors had elevated negative biases entering first-quarter 2021, reflecting the pressure on issuers across sectors amid the pandemic (see chart 5).

Chart 5


In the consumer services sector, negative rating actions during the year were concentrated among issuers within durable goods, apparel, cosmetics, dine-in restaurants, department stores, and specialty offerings. The consumer services rating bias improved considerably during the fourth quarter as optimism grew that a widely available vaccine in 2021 would enable a return to more normal activity. However, credit metrics in the most affected consumer services subsectors aren't expected to recover until 2022 or later. Credit deterioration in the sector has likely peaked, but default risk remains high with 36% of issuers rated 'B-' or lower.

Most rating actions in the energy and natural resources sector were among speculative-grade oil and gas companies. The sector's rating bias improved during the fourth quarter as prices increased. West Texas Intermediate (WTI) ended 2020 nearly $15 above our year-end price assumption. However, as the price of WTI remains near the average break-even price for U.S. shale (about $50 per barrel), weaker-rated companies, particularly those with large exposure to oil, will remain vulnerable. Nearly 30% of issuers in the sector are rated 'B-' or lower, with more distressed exchanges and bankruptcies expected over the next year. Within the oil and gas subsector, over 50% of issuers were rated 'B-' or lower at the end of 2020 (see chart 6).

Chart 6


Most rating actions in the leisure time/media sector were concentrated among travel-related issuers, local media, live events issuers, and movie exhibitors. The sector's rating bias improved considerably during the fourth quarter as vaccine optimism grew. The recovery for out-of-home entertainment issuers, such as those in the leisure, live events, and movie exhibitor subsectors, will depend on consumer behavior as the pandemic ends. However, a full recovery is unlikely before 2022, and even if consumer activity rebounds later this year, already weakened issuer credit metrics may not recover until 2023. Over 40% of issuers in the sector are rated 'B-' or lower, and more defaults are likely this year.

Chart 7


Upcoming maturities totals have dropped as a result of recent issuance. As of Jan. 1, only $130 billion is due in 2021, with roughly another $260 billion due in 2022 (see chart 8). These are small amounts compared with recent issuance totals, indicating any refinancing risk for the year ahead is also quite manageable. Moreover, over half of the speculative-grade debt due in 2021 is within the 'BB' category, which we expect to show muted default activity, if any.

Chart 8


Alongside the heady bond issuance totals in 2020, corporate spreads have continued to fall, even after the expiration of many of the Fed's recent liquidity facilities at year-end. 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 9). At the current level, the speculative-grade bond spread implies a default rate in line with our optimistic forecast by December 2021.

Chart 9


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 10).

Chart 10


The distress ratio (defined as the number of distressed credits, or speculative-grade issues with option-adjusted composite spreads of more than 1,000 bps 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 5% distress ratio in December corresponds to a roughly 2.2% default rate for September 2021. This is below even our optimistic forecast.

Market Optimism Appears Warranted

Investors are more optimistic than the underlying economy suggests. We build our estimate based on the VIX, the M1 money supply, and the Purchasing Managers' Index. We estimate that at the end of December, the speculative-grade bond spread in the U.S. was about 130 bps below the implied level (see chart 11), down from the all-time high of about 400 bps in February but still elevated. The gap is evidence that an optimistic outlook for businesses and the trajectory of the U.S. economy is the consensus among market participants.

Chart 11


We also present an alternative estimate for the speculative-grade spread, which is largely the same as our original estimate but replaces the M1 money supply with the difference between the M2 and M1 money supplies (often referred to as "near money"). Both the M1 and M2 grew substantially in 2020, but the M1 supply has increased to a much greater extent in recent months, largely due to a surge in demand deposits. Our alternate estimate finished 2020 at 401 bps, 33 bps below the actual spread, which implies current market optimism is appropriate.

Pessimistic Scenario: An Eventual Retreat In Support Could Expose Weaknesses

In our pessimistic scenario, we anticipate the default rate could increase to 9.5% from its current 6.6% (180 defaults) by December 2021. In previous quarters, our pessimistic scenario largely reflected the economic fallout of potential lockdowns in response to new waves of COVID-19. The fourth quarter saw this occur, but not to the economically crippling extent of the first wave in the second quarter.

Despite a bumpy start, vaccine deployment in the U.S. is proceeding; the country has hit a point where more vaccines have been administered than the number of new daily cases (as of Feb. 1). Another sizable round of fiscal stimulus is also on the way, which should support households, as well as state and local governments, through most of this year and after. That said, the potential remains for new waves of increased infection rates or mutations of the virus that could result in greater hospitalization or mortality rates; in a worst case, current vaccines may not be effective against new mutations.

Another risk behind an elevated default rate ahead is the potential that many firms on weak financial footing will have to face the world without such support as their need wanes with greater vaccination rates later this year. Speculative-grade ratings still show a clear deteriorating trend, with many firms rated 'CCC' to 'C' having been at this level for an extended period already.

Markets were supportive of these firms in 2020, but many of the more affected sectors have also issued more debt than in the recent past, increasing their debt loads while revenue flags. If market sentiment cools, borrowing costs rise, or the needed rebound in revenue falls short, financial stress should increase for many lower-rated issuers. In this scenario, we expect historical default rates for 'B-' and particularly for 'CCC' to '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 potential outcomes rather than simply a range. Given the nature of the virus, resulting containment measures, and fiscal and monetary responses thus far, it is also possible that regardless of which of the three outcomes is more accurate, defaults could follow a path resembling an elevated plateau or waves of heightened defaults, as opposed to the typical peak-and-trough cycles of the past (see chart 12).

Chart 12


Thus far, primary debt markets remain largely liquid, but revenue in many sectors has been flagging. This has laid 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 following 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. We expect the recovery in credit metrics will be uneven across sectors, with some not seeing a return to year-end 2019 levels until 2022 or after (see "COVID-19 Heat Map: Some Bright Spots In Recovery Amid Signs Of Stability," Feb. 17, 2021).

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% in December 2021 (57 defaults in the trailing 12 months) in our optimistic scenario and 9.5% (180 defaults in the trailing 12 months) in our pessimistic scenario.

We determine our forecast based on a variety of factors, including our proprietary analytical tool for U.S. speculative-grade issuer defaults.  The main components of the analytical tool 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 high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: 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;
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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