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COMMENTS

Default, Transition, and Recovery: The U.S. Speculative-Grade Corporate Default Rate Could Fall To 4% By March 2022

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Credit Trends: U.S. Corporate Bond Yields As Of Sept. 22, 2021

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2020 Annual European Structured Finance Default And Rating Transition Study Published

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Default, Transition, and Recovery: 2020 Annual European Structured Finance Default And Rating Transition Study


Default, Transition, and Recovery: The U.S. Speculative-Grade Corporate Default Rate Could Fall To 4% By March 2022

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S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to decline to 4% by March 2022 from 6.3% as of March 2021 (see chart 1).  Economic growth is set to pick up strongly this year on the back of increased COVID-19 vaccinations and fiscal stimulus measures. Meanwhile, the pace of corporate downgrades has slowed, and our rating outlook and CreditWatch distributions have improved recently.

In our optimistic scenario, we forecast the default rate will fall to 2.5%.  This scenario largely reflects what market signals are implying about future default activity. Fixed-income markets remain optimistic and liquidity abundant. Risk pricing among the weakest issuers is now at a decade low. Further fiscal stimulus aimed at infrastructure is a possibility, while private investment outside of nonresidential real estate has been particularly strong.

In our pessimistic scenario, we forecast the default rate will rise to 7.5%.  Our ratings distribution is particularly weak among speculative-grade firms. Just under 40% of our speculative-grade ratings ('BB+' or lower) are 'B-' or lower, leaving them vulnerable to a disruptive shock such as potential COVID-19 mutations or higher-than-expected inflation. Many issuers rated 'B-' or lower are in the sectors hardest hit by the pandemic, many of which we expect will take several years to return to 2019 credit metrics.

Chart 1

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We may also see a historically elevated default rate over the longer term.  With improving economic trends and optimistic economic forecasts, easing terms of debt financing, and improving credit trends, we anticipate further stabilization in creditworthiness rather than a wave of upgrades ahead. This will leave the already weak rating distribution in place, which may result in higher-than-average default rates (see chart 2). Extensive fiscal and monetary support has helped the economy and kept financial markets open and receptive through 2020. Nonetheless, many harder-hit sectors have a higher proportion of 'B-' and 'CCC'/'C' ratings--such as media and entertainment, at 48%.

Chart 2

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Credit Deterioration Slows

The sudden and acute recession in 2020 led to the sharpest credit deterioration ever in speculative-grade ratings. Amid the fast and robust economic rebound, the speculative-grade rating bias has rapidly recovered, but the number of upgrades has not yet matched the magnitude of downgrades seen last year.

With the strongly improved U.S. economic outlook for 2021, the speculative-grade negative bias (the proportion of issuers with negative rating outlooks or ratings on CreditWatch with negative implications) declined by 10 percentage points to 30% in the first quarter as many outlooks were revised to stable from negative. The speculative-grade negative bias is now just slightly elevated and has improved substantially since it reached an all-time high of 53% in the second quarter of 2020. In April, the negative bias fell further, to 26%.

While the speculative-grade positive bias (the proportion of issuers with positive rating outlooks or ratings on CreditWatch with positive implications) rose just slightly in the first quarter, to 8.4%, and remains somewhat low, the improved negative bias pushed the speculative-grade net negative bias (the positive bias minus the negative bias) higher, to -22%, for the first quarter. First-quarter 2021 marked the third consecutive quarter with fewer speculative-grade downgrades and more upgrades than in the previous quarter (see chart 4).

Chart 3

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Chart 4

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Sustained Improvement In Default Signposts

Measures of economic and financial conditions in the first quarter indicate a strong recovery and ample liquidity (see table). The Federal Reserve's survey on lending conditions fell to 5.5 in January, marking the largest drop over two quarters in the survey's history. Then, in April, the survey for large and middle-market firms fell again to -15.1, reflecting the easiest lending standards for these firms since 2018. The survey also reported the easiest lending standards for small firms since 2013 (the net percentage of respondents reporting tightening standards for commercial and industrial loans to small firms during the first quarter was -12.9%).

There were periods of market volatility during the first quarter, with the VIX spiking higher in January and February, but volatility remains on a downtrend. The volatility during the quarter had only a muted impact on credit in January and no impact in February, with the speculative-grade credit spread continuing to grind tighter, to 391 basis points (bps) at the end of March. Economic and financial data has shown sustained improvement, but further improvement during the recovery may come more slowly, and some downside risk remains.

Indicators Of Credit Stress Continued To Improve In The First Quarter
2021Q1 2020Q4 2020Q3 2020Q2 2020Q1 2019Q4 2019Q3 2019Q2 2019Q1
U.S. unemployment rate (%) 6.0 6.7 7.8 11.1 4.4 3.6 3.5 3.6 3.8
Fed Survey on Lending Conditions 5.5 37.7 71.2 41.5 0.0 5.4 (2.8) (4.2) 2.8
Industrial production (% chya) 1.0 (3.4) (6.1) (10.5) (4.7) (0.8) (0.2) 1.0 2.3
Slope of the yield curve (10-year less 3-month) (bps) 171 84 59 50 59 37 (20) (12) 1
Corporate profits (nonfinancial) (% chya) (2.4) 2.8 (18.8) (5.7) 1.3 (0.3) 0.5 (3.3)
Equity market volatility (VIX) 19.4 22.8 26.4 30.4 53.5 13.8 16.2 15.1 13.7
High-yield spreads (bps) 390.8 434.4 576.9 635.9 850.2 399.7 434.1 415.6 385.2
Interest burden (%) 7.7 7.3 8.6 7.9 7.5 7.7 7.7 7.9
S&P Global Ratings distress ratio (%) 3.4 5.0 9.5 12.7 35.2 7.5 7.6 6.8 7.0
S&P Global Ratings U.S. speculative-grade negative bias (%) 29.9 40.4 47.5 52.4 37.1 23.2 21.4 20.3 19.8
Ratio of downgrades to total rating actions (%)* 35.0 56.5 70.4 95.2 90.4 82.9 82.9 69.6 76.0
Proportion of spec-grade initial issuer ratings 'B-' or lower (%) 49.5 57.9 44.8 71.7 54.7 39.6 39.6 41.7 39.6
U.S. weakest links (count) 265 339 390 429 316 195 178 167 150
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.

Trend Of Fewer Defaults Continues

While a recovery in speculative-grade credit quality may lag the overall economic recovery, we've likely seen the peak in the speculative-grade default rate from this recession. Defaults continued to trend lower in the first quarter as the economic recovery became faster and stronger than expected, and as credit markets continued to provide record amounts of liquidity to speculative-grade issuers (see chart 5).

Chart 5

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Rating actions in 2020 led to a much weaker overall ratings distribution among speculative-grade entities, but this has varied across industries (see chart 6). Some sectors, including media and entertainment (which includes lodging, gaming, and other point-of-contact-based entertainment), discretionary consumer products, discretionary retail, and oil and gas, contributed more defaults than others in 2020, given particularly weak rating distributions--for the most part, they have more issuers rated 'CCC'/'C' than the overall speculative-grade segment.

Thus far, we have largely expected this divergence, which is consistent with S&P Global economists' expectation of a K-shaped economic recovery over the next few years. These sectors will likely see slower financial recoveries and should also lead the default tally over the next 12 months.

Chart 6

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In the first quarter, consumer services (four), energy and natural resources (three), and leisure time/media (three) continued to lead defaults. These three sectors accounted for nearly three-quarters of the defaults in 2020 as they felt a disproportionate impact from the sudden recession and the collapse in oil prices.

Yet even as the consumer services and energy and natural resources sectors continued to lead the default tally in the first quarter, we've seen fewer defaults from these industries for three consecutive quarters, and defaults in the leisure time/media sector fell for two consecutive quarters before rising slightly in the first quarter. The outlooks for these sectors have improved along with the U.S. economic outlook for 2021.

The outlook for the consumer services sector has improved with expectations for stronger consumer spending in 2021. Even so, credit metrics for issuers in discretionary retail may not recover until 2022, and issuers in discretionary consumer products may not recover until 2023.

Meanwhile, the outlook for the energy and natural resources sector has improved as OPEC+ supply cuts continue to support oil prices and as demand recovers during the economic recovery. However, as the price of West Texas Intermediate is unlikely to remain far above the average break-even price for U.S. shale (near $50), and as capital expenditure will likely remain limited in the oil and gas industry in the near term, speculative-grade oilfield services and exploration and production companies will remain vulnerable.

Within the leisure/time media sector, the outlook has improved for some issuers as advertising trends have strengthened with the economy. However, issuers in the sector remain at risk of negative rating actions during the recovery after the pandemic worsened secular pressures. The time frame of recovery for the sector's out-of-home entertainment issuers will depend on consumer behavior as the economy reopens, but issuer credit metrics may not recover until 2023.

Issuance And Pricing Show Heady Optimism

Strong issuance totals in the latter part of 2020 have continued into 2021. As economic activity recovers, ample liquidity has been available to speculative-grade issuers, which continues to limit defaults. Speculative-grade debt issuance through April reached $449 billion--an amount normally seen several months later in the year, based on recent experience (see chart 7). Issuance began the year strong and then accelerated in March as U.S. Treasury yields continued to rise, with the 10-year yield reaching an intraday high of 1.77% after ending 2020 at 0.93%.

Chart 7

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The quick rise in Treasury yields added to investor demand for floating-rate debt, with a quarterly record in collateralized loan obligation issuance and strong inflows into retail loan funds. With strong loan demand, leveraged loan issuance in the first quarter reached a new quarterly record of $225.9 billion.

Strong demand from investors searching for yield also pushed speculative-grade bond issuance to record levels again in the first quarter. Total issuance reached $158.6 billion through April, up substantially from the $92.1 billion through April 2020. Issuance was strong in every speculative-grade rating category in the quarter, with the $51.1 billion of issuance in the 'B' rating category marking an all-time high for quarterly issuance, and the $14.6 billion of 'CCC'/'C' issuance nearly matching the record set in fourth-quarter 2007.

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 391 bps at the end of March, the speculative-grade bond spread implies a 2.3% default rate by March 2022.

Chart 8

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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).

Chart 9

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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 3.4% distress ratio in March, the lowest since October 2007, corresponds to a 2% default rate for December 2021.

Market Optimism Appears Warranted

Using the VIX, the currency component of M1 plus demand deposits, and the ISM purchasing managers' index, we estimate that at the end of March, the speculative-grade bond spread in the U.S. was about 12 bps below the implied level (see chart 10). This suggests investors' optimistic outlook for businesses and the trajectory of the U.S. economy has been warranted.

Chart 10

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A Weak Ratings Distribution Vulnerable To Stressors

In our pessimistic scenario, we anticipate the default rate could increase to 7.5% from its current 6.3% (145 defaults) by March 2022. This scenario acknowledges that despite an easing in downgrades and negative bias in recent months, our rating distribution remains very weak as a result of the large number of downgrades during 2020. Nearly 40% of all our U.S. speculative-grade ratings are 'B-' or lower, making them vulnerable to any disruption in the economy or financial markets.

The most likely disruptions as of this writing include potential COVID-19 mutations or a greater-than-expected jump in inflation. Unsurprisingly, many weaker ratings are in sectors that have been hardest hit by the pandemic, with over 18% at 'B-' or lower in the media and entertainment sector alone. These weaker sectors that are expected to have yearslong recoveries could see longer-term solvency troubles and will remain on our watchlist for the next several years.

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 2.5% in March 2022 (48 defaults in the trailing 12 months) in our optimistic scenario and 7.5% (145 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.  Factors we focus on 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: 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
Research Contributor:Shripati Pranshu, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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