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Default, Transition, and Recovery: Growing Strains Could Push The U.S. Speculative-Grade Corporate Default Rate To 4% By December 2023


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Default, Transition, and Recovery: Growing Strains Could Push The U.S. Speculative-Grade Corporate Default Rate To 4% By December 2023


S&P Global Ratings Credit Research & Insights expects the U.S. trailing-12-month speculative-grade corporate default rate to reach 4% by December 2023, from 1.7% in December 2022 (see chart 1).  This base-case scenario is more than double the current default rate and just shy of the 4.1% long-term average. Since our last update, U.S. GDP increased more than many expected in the fourth quarter, and both the headline Consumer Price Index and Producer Price Index continued to decline. But aggregate corporate earnings appear to be contracting, based on results so far, and many banks are prepping for a recession.

Revenue will feel the strain as growth slows, even barring a recession, and an expected rising unemployment rate will negatively affect consumer-reliant sectors, which make up about half of issuers rated in the 'CCC' to 'C' categories. Interest rates remain elevated with little reason to suspect they will decline meaningfully by year-end, adding to increased costs for firms. Meanwhile, upcoming maturities are manageable, but some issuers that need to refinance fixed-rate debt may still experience sticker shock from current rates.

Chart 1


In our optimistic scenario, we forecast the default rate could hit 1.75%.  In this scenario, current positive trends in economic growth, slowing wage gains, and falling inflation will bring the economy to the much-touted "soft landing" scenario, with the Federal Reserve opting for fewer, or smaller, rate hikes. A recession is avoided and unemployment remains low, allowing consumers to avoid any major pullback in spending and keeping companies afloat. Wages and other input costs would start to decline, and borrowing costs could also fall as the reopening of primary markets spurs a rebound in bond and loan issuance with market confidence ultimately restored.

In our pessimistic scenario, we forecast the default rate could rise to 6%.  For now, we assume the upcoming recession will be relatively short-lived and not especially deep. That said, if a more widespread, deeper, or longer downturn were to occur, defaults could rise materially from their current low levels. Inflation remaining high could exacerbate this, forcing the Fed to keep rates elevated or continue raising them longer than expected. The combination of slower growth, higher unemployment, falling revenue, rising costs, and higher interest rates would prove challenging, especially for the historically high proportion of issuers rated 'B-' and 'CCC' to 'C'.



Bond And Loan Markets May Be Diverging

Economic data has been providing mixed signals for investors to chew over. Now, perhaps, financial markets are joining in. Speculative-grade (rated 'BB+' or lower) issuers in the U.S. are funded largely via two sources: high-yield bonds and leveraged loans. Given the riskiness of the underlying issuers, these two markets often reflect similar credit risk in pricing and issuance trends.

However, recently bond investors--who typically take a longer view--are adopting a more optimistic stance and hoping for a Fed pivot in late 2023. In contrast, leveraged loans pay floating rates that are tied to shorter-term benchmarks such as the three-month LIBOR or SOFR. As a result, loan pricing in the past year has moved nearly in lockstep with the upward trajectory of the fed funds rate.

Interest rate volatility in all markets during 2022 limited the issuance of both high-yield bonds and leveraged loans, despite back-and-forth movement in secondary bond yields. But now, with much stronger-than-expected results for fourth-quarter GDP (2.9%) and on the labor front (half a million jobs created in January, with falling wages and unemployment now at a 50-plus-year low) alongside continuously falling inflation, bond markets are looking past the near-term Fed rate increases, and spreads have compressed further.

Meanwhile, banks have reported building buffers in anticipation of a recession and have tightened their standards on commercial and industrial loans to near-recession levels. In other words, the usually strongly correlated financing conditions for high-yield bonds and loans appears to be diverging (see chart 2).

Chart 2


And this divergence is also showing up in primary markets, with bond and leveraged loan issuance moving in opposite directions (see chart 3). High-yield bond issuance came back in line with typical January totals this year after falling most months in 2022. Meanwhile, leveraged loans only mustered a historically paltry $18 billion in January, when levels are often in excess of $50 billion.

Chart 3


However, even if markets don't completely shake their 2022 hesitation this year, maturities through 2024 remain manageable (see chart 4). We estimate $378.5 billion in total speculative-grade debt will be coming due through 2024, with $57.2 billion of that attributable to the 'CCC' to 'C' categories. Of the $115.3 billion total due this year, a majority is from the 'BB' category, reflecting a lower likelihood of default. That said, 'B' maturities will pick up in 2024, and the aggregate total expands at a faster pace to $419.2 billion in 2025.

Chart 4


The relative risk of holding corporate bonds can be a major indicator of future defaults because of the 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 5). At 415 basis points (bps) in December 2022, the speculative-grade bond spread implied around a 2.4% default rate by December 2023.

Chart 5


While the speculative-grade spread is a good indicator of broad market stress, 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 (the proportion of speculative-grade issues with option-adjusted spreads of 1,000 bps or more over comparable Treasuries) is a more targeted indicator of future defaults across all points in credit and economic cycles (see chart 6).

Chart 6


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 similar to the speculative-grade spread, but with a nine-month lead time as opposed to one year. The 7.3% distress ratio in December implies about a 2.6% default rate for September 2023.

Some Spread Widening Expected Amid Mixed Signals

Using the Volatility Index (VIX), the ISM Purchasing Managers' Index, and components of the money supply, we estimate that at the end of December, the speculative-grade bond spread in the U.S. was about 240 bps below the implied level (see chart 7). Bond markets have turned much more optimistic in the past two months after multiple positive updates on economic data. However, given the still-high likelihood of a recession, alongside higher rates from the Fed, falling earnings, and a still-dour loan market, we expect the speculative-grade spread to widen as the year unfolds.

Chart 7


We expect credit conditions will remain restrictive over the next 12 months. The Federal Reserve will continue to clamp down on market liquidity this year, and we expect policy rates will remain higher for longer. Market participants have readjusted their expectations for the path of the fed funds rate following the February Federal Open Market Committee decision--repricing in another 25 bps hike and a terminal rate of 500 bps to 525 bps by May. However, market expectations for a pivot in the fourth quarter remain priced in, despite consistently contrary forward guidance from the Fed. Speculative-grade yields will likely remain elevated this year and into 2024--even amid a soft landing.

These mixed signals are setting the stage for a challenging market for investors to navigate in 2023. We believe the key risk to monitor this year is liquidity--primary market activity, balance-sheet liquidity, and cash flow. Our rating actions since second-half 2022 show that the momentum of credit deterioration is slowly building, and corporate earnings appear to already be declining.

Amid difficult macroeconomic conditions, the labor market and spending on services will be key areas of focus this year. We expect the Federal Reserve will maintain its restrictive policy stance to bring inflation back toward its 2% target--and financial conditions could be very tight entering 2024. At the same time, we expect economic growth will decelerate over the next 12 months. If it decelerates below trend in 2023, it will be important to monitor primary markets, given the speculative-grade maturity wall grows in 2024 and is notably higher in 2025.

Mixed Signals Muddy The Outlook
U.S. unemployment rate (%) Fed survey on lending conditions Industrial production (% change YoY) Slope of the yield curve (10-year less 3-month) (bps) Corporate profits (nonfinancial) (% change YoY) Equity market volatility (VIX) High-yield spreads (bps) Interest burden (%) S&P Global Ratings distress ratio (%) S&P Global Ratings U.S. SG negative bias (%) Ratio of downgrades to total rating actions (%)* Proportion of SG initial issuer ratings 'B-' or lower (%) U.S. weakest links (no.)
2019Q1 3.8 2.8 0.6 1 4.2 13.7 385 9.0 7.0 19.8 73.3 39.6 150
2019Q2 3.6 -4.2 -0.6 (12) 7.2 15.1 416 9.0 6.8 20.3 67.3 40.8 167
2019Q3 3.5 -2.8 -1.5 (20) 5.0 16.2 434 9.0 7.6 21.3 81.5 37.7 178
2019Q4 3.6 5.4 -2.0 37 1.7 13.8 400 8.8 7.5 23.2 81.0 39.6 195
2020Q1 4.4 0 -4.9 59 -4.1 53.5 850 9.0 35.2 37.1 89.9 54.8 316
2020Q2 11 41.5 -10.6 50 -17.5 30.4 636 9.2 12.7 52.4 94.6 71.7 429
2020Q3 7.9 71.2 -6.3 59 1.1 26.4 577 7.9 9.5 47.5 63.3 45.5 390
2020Q4 6.7 37.7 -3.6 84 -4.9 22.8 434 8.1 5.0 40.4 50.0 57.9 339
2021Q1 6.1 5.5 1.0 171 13.8 19.4 391 7.6 3.4 29.9 30.6 49.5 265
2021Q2 5.9 -15.1 9.2 140 37.5 15.8 357 7.2 2.3 20.6 24.1 41.8 191
2021Q3 4.8 -32.4 3.9 148 14.0 23.1 357 7.2 2.6 16.0 27.3 36.1 155
2021Q4 3.9 -18.2 3.7 146 20.7 17.2 351 7.1 2.6 14.1 34.5 33.3 131
2022Q1 3.6 -14.5 4.8 180 6.1 20.6 346 7.1 2.7 12.5 36.0 30.9 121
2022Q2 3.6 -1.5 3.7 126 5.0 28.7 546 6.6 8.3 13.8 46.9 46.3 127
2022Q3 3.5 24.2 5.0 50 3.5 31.6 481 6.1 7.9 16.7 57.8 52.6 144
2022Q4 3.5 39.1 1.645559544 (54) 21.7 415 7.3 19.1 76.0 71.4 195
Notes: Fed survey refers to net tightening for large firms. S&P Global Ratings' negative bias is defined as the percentage of firms with negative bias of those with either negative, positive, or stable bias. *Speculative-grade only. YoY--Year over year. Bps--Basis points. SG--Speculative-grade. Sources: Economics and Country Risk from IHS Markit; Board of Governors of the Federal Reserve System (U.S.); Bureau of Labor Statistics; U.S. Bureau of Economic Analysis; Chicago Board Options Exchange's CBOE Volatility Index; and S&P Global Ratings Credit Research & Insights.

Rating Pressure Will Build As Credit Headwinds Linger

Upgrades have stalled, and downgrades are rising. Negative rating momentum may continue to build slowly after many issuers benefited from now-diminishing cushions built up since the 2020 recession. While speculative-grade credit quality could remain somewhat resilient in a shallow recession, the buildup of 'B-' rated issuers adds to downside risk, and this could contribute to a sharper deterioration among speculative-grade ratings (see chart 8).

Chart 8


For the fourth quarter, just three sectors had a positive net bias (positive bias, or the proportion of ratings with positive outlooks or CreditWatch implications, minus negative bias). Net biases worsened in all but the transportation sector, and seven sectors now show negative net rating actions (upgrades minus downgrades on a trailing-12-month basis) (see chart 9). This signals a turning point for speculative-grade ratings. Credit deterioration continued through January, and issuers will confront a host of credit headwinds over the next 12 months.

Chart 9


Five sectors stand out in the current conditions: consumer services, leisure, aerospace/auto/capital goods/metals, high tech, and health care. Combined, these five sectors account for nearly 77% of speculative-grade issuers with negative bias and 81% of weakest links (issuers rated 'B-' or lower with negative outlooks or CreditWatch implications):

  • Some consumer/service issuers are reporting weak operating results. Inflation, supply-chain tightness, and challenging macroeconomic conditions are weighing on issuer credit quality.
  • We also expect weaker macroeconomic conditions to pressure credit quality for some leisure issuers, especially those exposed to advertising spend--with a slowdown already evident. There is divergence in the sector, though, with credit quality for some issuers underpinned by improved fundamentals as social activity and spending on services continue to normalize.
  • Within the aerospace/automotive/capital goods/metals sector, capital goods and auto issuers are taking hits from persistent inflationary pressure and supply-chain disruptions.
  • Rising interest expense is pressuring issuer cash flow, specifically for issuers that rely on the leveraged loan market for capital. We already see evidence of this for some highly leveraged issuers in high technology and health care, and issuers in these sectors are also contending with macroeconomic challenges more broadly.

Chart 10


Chart 11


As downgrades of speculative-grade issuers have increased in the past three months in the U.S., the share of issuers rated 'CCC' to 'C' has grown (see chart 12). In fact, the downgrade rate from the 'B' category has risen sharply, to 6% in the 12 months ended December 2022, from a low of 1.5% at the end of 2021. These lowest-rated issuers have historically had a much higher default rate at any point in the credit cycle and will be more vulnerable to default if current challenges persist or grow.

Chart 12


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 December 2023 (32 defaults in the trailing 12 months) in our optimistic scenario and 6% (109 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.

Credit Research & Insights:Nick W Kraemer, FRM, New York + 1 (212) 438 1698;
Jon Palmer, CFA, Austin 212 438 1989;
Research Contributor:Shripati Pranshu, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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