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COMMENTS

Default, Transition, and Recovery: The U.S. Speculative-Grade Corporate Default Rate Could Reach 3.5% By June 2023

COMMENTS

Credit Trends: U.S. Corporate Bond Yields As Of Sept. 21, 2022

COMMENTS

Default, Transition, and Recovery: Quarterly Default Update Q2 2022: Defaults And Spreads Up, Issuance Dramatically Down

COMMENTS

Default, Transition, and Recovery: U.S. Defaults In August Alone Account For 25% Of Regional Year-To-Date Total

COMMENTS

Credit Trends: U.S. Corporate Bond Yields As Of Sept. 14, 2022


Default, Transition, and Recovery: The U.S. Speculative-Grade Corporate Default Rate Could Reach 3.5% By June 2023

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Chart 1

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S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to reach 3.5% by June 2023, from 1.4% in June 2022 (see chart 1).   This base-case scenario more than doubles the current default rate, but it is still lower than the long-term average of 4.2%. Since our last update, the U.S. suffered a second consecutive quarter of declining GDP, more interest rate increases, and largely higher inflation readings. Our economists have increased their recession odds to 45%, and general sentiment indicators show less optimism ahead. That said, many firms are well-placed to withstand a downturn. Many have built up large cash reserves since 2020, and refinanced existing debt on very favorable terms. The default rate remains low, but much will depend on the length, breadth, and depth of a recession should one occur. For now, ratings have remained stable and not seen any substantial downward momentum.

In our optimistic scenario, we forecast the default rate could hit 1.75%.   In this scenario, inflation will peak in the next few months (if it hasn't already), with the Fed staying any further hikes and likely lowering rates back sometime in early-to-mid 2023. A recession is avoided, and energy prices see some of their recent declines continue, allowing consumers to avoid any major pullback in spending, keeping firms afloat. Meanwhile, input and borrowing costs would also fall, opening primary markets for a resumption of normal borrowing activity after this year's relative drought.

In our pessimistic scenario, we forecast the default rate could rise to 6%.   For now, we assume that if there is a recession, it will be relatively short-lived and not especially deep in terms of economic contraction. That said, if a more widespread, deeper, or longer downturn were to occur, this could drive up defaults materially from their current low levels. This could be further exacerbated if inflation were to remain high, forcing the Fed to keep rates elevated or continue raising them longer than currently expected.

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Recession Odds Rising But Perhaps With Limited Impact

The second quarter saw continued increases in inflation, as well as borrowing costs. The July consumer price index (CPI) came in lower than expected, and some are hoping this is the first sign of inflation having reached its peak, allowing the Fed to pause interest rate hikes once the fed funds rate reaches roughly 3.75%. That said, consumer and CEO confidence fell, and consumer inflation expectations (as well as for equity declines down the road) have both increased (see chart 2). In fact, the Conference Board's index for inflation 12 months ahead reached an all-time high of 7.9% at the end of June, falling to 7.6% in July. Meanwhile, roughly 46% of respondents expect stock prices to decrease over the next 12 months--the highest point since the U.S. downgrade in the summer of 2011.

Chart 2

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Not all are expecting the worst. Credit markets seem to be saying two distinct things through yield pricing and spreads: 1) that a recession is becoming more and more likely, and 2) they don't particularly care (see chart 3). Since June, the yield curve (defined as the different in yields on 10-year Treasuries and 3-month Treasuries) has fallen more quickly than at any point in the last 35 years to nearly below zero.

Yield curve inversions tend to be very reliable leading indicators of recession. At the same time, our speculative-grade bond spread has fallen almost 170 basis points (bps)to 395 bps on Aug. 10 from 564 bps on July 5, indicating a quick positive turnaround for bond market sentiment. This could indicate markets are anticipating a short and shallow recession ahead, along with higher expectations the Fed will begin lowering rates early in 2023. At this time, our economists are placing recession odds in the next 12 months at roughly 45% (within a range of 40%-50%), and they expect it to be a slow growth recession rather than a marked contraction.

Chart 3

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That said, favorable trends in secondary markets have not yet spilled over into primary markets. Issuance remains weak, and it is likely too early to completely rule out continued rate increases by the Fed, or for the Fed to keep rates high for longer once they reach its target levels, particularly if inflation falls more slowly than previous increases have seen.

Volatility Pushes Up Borrowing Costs And Slows Primary Markets

Speculative-grade debt issuance remained sparse in the second quarter, and in July, the cost of funding for all speculative-grade issuers reached restrictive territory, with leveraged loan issuance plummeting to $21.3 billion and just $1.8 billion of speculative-grade bonds issuance (see chart 4). We expect primary markets to remain challenging, but refinancing risk is currently low and the recent recovery in market sentiment opens a window for issuers in need of capital. The cost of funding will likely remain restrictive for the weakest-rated issuers, though, as slowing growth, inflation, supply-chain disruptions, and rising interest expense will likely increasingly strain cashflows.

Chart 4

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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). At 546 bps, the speculative-grade bond spread implied a 3.4% default rate by June 2023.

Chart 5

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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 credit and economic cycles (see chart 6).

Chart 6

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The distress ratio 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 similar to the speculative-grade spread, but with a nine-month lead time as opposed to one year. The 8.3% distress ratio in June corresponded to a 2.8% default rate for June 2023.

Some Spread Widening Is Likely In 2022

Using the VIX, the Institute of Supply Management (ISM) purchasing managers index, and components of the M2 money supply, we estimate that at the end of July the speculative-grade bond spread in the U.S. was about 148 bps below the implied level (see chart 7). We expect widening in the spread to resume this year as headwinds increasingly pressure credit quality.

Chart 7

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Credit conditions quickly tightened in the second quarter as the Federal Reserve aggressively raised interest rates and the economy weakened in the first half of 2022. Optimism returned to the markets in mid-June amid expectations that front-loaded rate hikes from the Federal Reserve would bring inflation under control. Sharp tightening of the speculative-grade spread in the third quarter has followed. With signs that inflationary pressure eased in July, the spread is now over 150 bps below its widest level of the year (564 bps in early July).

Although the U.S. has posted two consecutive quarters of contractions, economic weakness has not yet shown up in the labor market, and consumers have continued to spend despite the pressure on budgets from a 40-year high in inflation. This may point to softer landing for the U.S. economy. Even so, we expect economic activity to remain weak through 2023.

Short-term rates are still set to rise further, and it is unlikely that the Federal Reserve reverses course anytime soon. Inflation is far above its target of 2%, and slack in the labor market has yet to form. We expect credit market conditions to remain challenging over the next 12 months, especially for the weakest speculative-grade issuers.

Table 1

Credit Conditions Are Quickly Tightening
U.S. unemployment rate (%) Fed survey on lending conditions Industrial prod. (% chg. YoY) Slope of the yield curve (10 year to three month; bps) Corporate profits (nonfinancial; % chg. YoY) Equity Market Volatility (VIX) High yield spreads (bps) Interest burden (%) S&P Global distress ratio (%) S&P Global U.S. SG negative bias (%) Ratio of downgrades to total rating actions* (%) Proportion of SG initial issuer ratings of 'B-' or lower (%) U.S. weakest links (no.)
2018Q1 4.0 (10.0) 3.2 101 11.9 20.0 330 9.6 5.4 18.0 48.4 34.3 137
2018Q2 4.0 (11.3) 2.9 92 10.7 16.1 332 9.0 5.1 17.8 59.2 32.4 143
2018Q3 3.7 (15.9) 4.4 86 11.1 12.1 301 8.5 5.7 18.4 51.4 29.7 144
2018Q4 3.9 (15.9) 2.4 24 11.8 25.4 482 8.3 8.7 19.3 65.9 33.3 144
2019Q1 3.8 2.8 0.6 1 0.8 13.7 385 8.6 7.0 19.8 73.3 40.4 150
2019Q2 3.6 (4.2) (0.6) (12) 5.1 15.1 416 8.5 6.8 20.3 67.3 41.7 167
2019Q3 3.5 (2.8) (1.5) (20) 2.8 16.2 434 8.3 7.6 21.3 81.5 37.7 178
2019Q4 3.6 5.4 (2.0) 37 (0.3) 13.8 400 8.1 7.5 23.2 81.0 39.6 195
2020Q1 4.4 0.0 (4.9) 59 (3.8) 53.5 850 8.2 35.2 37.1 89.9 54.7 315
2020Q2 11.0 41.5 (10.6) 50 (18.3) 30.4 636 8.4 12.7 52.4 94.6 71.7 430
2020Q3 7.9 71.2 (6.3) 59 2.1 26.4 577 7.2 9.5 47.5 63.3 45.5 392
2020Q4 6.7 37.7 (3.6) 84 1.1 22.8 434 7.2 5.0 40.4 50.0 57.9 340
2021Q1 6.0 5.5 1.0 171 14.7 19.4 391 7.2 3.4 29.9 30.6 49.5 266
2021Q2 5.9 (15.1) 9.2 140 43.4 15.8 357 7.1 2.3 20.6 24.1 41.5 191
2021Q3 4.7 (32.4) 3.9 148 18.2 23.1 357 6.8 2.6 16.0 27.5 36.1 160
2021Q4 3.9 (18.2) 3.7 146 19.7 17.2 351 6.7 2.6 14.1 34.5 32.4 131
2022Q1 3.6 (14.5) 4.9 180 8.8 20.6 346 6.7 2.7 12.5 36.0 30.2 121
2022Q2 3.6 (1.5) 4.2 126 28.7 546 8.3 13.8 46.4 45.2 127
2022Q3 24.2
SG--Speculative grade. Chg. YoY--Change from a year ago. Bps--Basis points. Note: Fed Survey refers to net tightening for large firms. S&P Global's negative bias is defined as the percentage of firms with a negative bias of those with either a negative, positive, or stable bias. *Speculative-grade only. Sources: Economics and Country Risk from IHS Markit, Board of Governors of the Federal Reserve System (US), Bureau of Labor Statistics, U.S. Bureau of Economic Analysis, Chicago Board Options Exchange's CBOE Volatility Index, and S&P Global Ratings Research.

Rating Momentum Hit By Headwinds

Speculative-grade upgrades continued to slow in the second quarter, and downgrades have crept higher. As growth decelerates and financial conditions tighten, we expect positive rating actions will continue to trend lower, but because many issuers benefitted from cushions built up since the 2020 recession, negative rating momentum may not pick up immediately. While speculative-grade credit quality could remain somewhat resilient in a shallow or low-growth recession, the buildup of 'B-' rated issuers would contribute to sharper deterioration if headwinds--slowing or low growth, inflation, supply-chain disruptions, and rising interest expense--worsen or persist (see chart 8).

Chart 8

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For the second quarter, four sectors had a positive net bias, and only the real estate sector had negative net rating actions (see chart 9). Downgrades in the real estate sector consist largely of property developers in the People's Republic of China incorporated in the Cayman Islands, a tax haven that we group in the U.S. region (along with Bermuda). We have seen several negative rating actions involving property developers in China as it has been difficult for some issuers to maintain sufficient liquidity.

Chart 9

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Sectors To Watch

There are five sectors that stand out in the current environment.

Some consumer/service issuers are reporting weak operating results. Inflation, supply-chain disruptions, and less favorable macroeconomic conditions are expected to weigh on issuer credit quality.

Weaker macroeconomic conditions are expected to pressure credit quality for some leisure issuers, especially those exposed to advertising spending. We already see evidence of a slowdown in broadcast radio advertising. There is divergence in the sector though, as credit quality for other issuers remains underpinned by improved fundamentals and continued normalization in social activity following the extreme effects of mandatory business closures and mass social distancing.

Within the aerospace/automotive/capital goods/metal sector, capital goods and automotive issuers are seeing effects from the persistence of inflation and supply-chain disruptions.

We expect rising interest expense to increasingly pressure issuer cashflows, and we already see this for some highly leveraged issuers in high technology and health care.

These sectors combined account for nearly 77% of speculative-grade issuers with a negative bias and over 88% of weakest links.

Credit Migration Risk By Sector

Chart 10

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Chart 11

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Despite overall stability within the U.S. speculative-grade population, much of the speculative-grade population is more vulnerable now than is historically typical (see chart 12). Though showing a decline over the last year or so, the proportion of speculative-grade issuers with a 'B-' or lower rating has slowed its recent decent, and these issuers could be more vulnerable to default if current challenges persist or grow.

Chart 12

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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 1.75% in June 2023 (33 defaults in the trailing 12 months) in our optimistic scenario and 6% (113 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 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.

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 212 438 1989;
jon.palmer@spglobal.com
Research Contributor:Shripati Pranshu, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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