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Credit Trends: Growing Risks, Diminishing Rewards--Has The U.S. Speculative-Grade Market Hit A Peak?


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Credit Trends: Growing Risks, Diminishing Rewards--Has The U.S. Speculative-Grade Market Hit A Peak?

(Editor's Note: This article is the second in a series covering aspects of the speculative-grade market, including how it has evolved prior to and as a result of the COVID-19 pandemic, as well as expectations for speculative-grade ratings and market performance.)

With the help of massive fiscal and monetary support that began in 2020, S&P Global Ratings' U.S. speculative-grade corporate default rate, while elevated, stayed well below the peaks of prior recessions and well below our projections. Markets provided (and sustained) the needed liquidity for firms to issue debt to ride out the economic lockdowns of the COVID-19 pandemic. But this left a larger debt pile for firms to pay off in the future. More debt, combined with less revenue in 2020, resulted in higher leverage and a large number of downgrades, particularly at the lower end of the ratings spectrum.

Downgrades Have Left A Vulnerable Foundation

Recent downgrades, expectations that certain sectors will take an extended time to repair their balance sheets, ongoing structural changes for some sectors, and a large number of new issuers with initial ratings of 'B-' or lower all contributed to our speculative-grade ratings distribution reaching its weakest point ever in late 2020, with 40% rated 'B-' or lower. This ratio has remained elevated through mid-2021 (see chart 1).

History has shown these weaker ratings carry an average chance of downgrade or default above 20% over a one-year time frame (see chart 2). We do not envision another large wave of downgrades at this time, but the fact remains that speculative-grade ('BB+' or lower) corporate issuers are much more vulnerable to declines in credit quality than historically because of the current ratings distribution.

And Payoffs Are Dwindling

The inherent credit risk embedded in the current U.S. speculative-grade market should demand strong compensation for investors, but just the opposite is now true. Real (inflation-adjusted) yields on speculative-grade corporate bonds turned negative for the first time ever in April (see chart 3). Even 'B' real yields fell below zero in June.

This shows that in "real" terms, investors are paying to lend, and any near-term price returns will likely be minimal, if even positive. In the year to date (through Sept. 7), the S&P U.S. High Yield Corporate Bond Index has returned 4.5%--down from 6.8% in 2020--with most of these gains coming prior to early July.

Real yields have fallen quickly in the past 12-15 months as both nominal corporate yields have reached new lows and inflation has risen. S&P Global economists as well as the Federal Reserve believe the recent jump in inflation will prove transitory. This may also be a key assumption of speculative-grade debt investors, and it could be the reason so many are willing to accept negative real yields on such risky instruments--for the time being. However, if inflation remains high for longer than expected, real yields could remain negative or otherwise historically low.

Strong economic growth is likely already priced into markets, so if recent concerns over a slower pace of recovery grow at a time when the incentives to hold speculative-grade debt have shrunk, the speculative-grade market might have hit a peak, which could cause investors to exit and lead to issuers facing tighter financing conditions or even more credit stress ahead.

Chart 1


Chart 2


Chart 3


Related Research

This report does not constitute a rating action.

Ratings Performance Analytics:Nick W Kraemer, FRM, New York + 1 (212) 438 1698;

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