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Default, Transition, and Recovery: Growing Strains Will Push The U.S. Speculative-Grade Corporate Default Rate To 4.25% By March 2024


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Default, Transition, and Recovery: Growing Strains Will Push The U.S. Speculative-Grade Corporate Default Rate To 4.25% By March 2024


S&P Global Ratings Credit Research & Insights expects the U.S. trailing-12-month speculative-grade corporate default rate to reach 4.25% by March 2024, from 2.5% in March 2023 (see chart 1).   Our base case projection calls for defaults to continue rising to at least 1.75% above their current rate. Rising rates and still elevated input costs (including labor) have been eroding profitability and estimates for first-quarter earnings call for declining profits relative to a year ago, in aggregate. Corporates may already be in an earnings recession, growth is expected to slow, while interest rates will likely remain elevated (if unlikely to continue rising or to the same extent as the increases of 2022). Downgrades and defaults resulting from falling cash flow and rising debt costs have increased and affected many sectors. Although inflation continues to fall, the pace of declines appears too slow to warrant a Federal Reserve pivot that markets currently expect. The timing and extent of a potential confluence of rising rates, rising costs, and slowing growth could push the default rate higher still.

Chart 1


In our optimistic scenario, we forecast the default rate could fall to 1.75%.   In this scenario, economic resilience would continue alongside falling inflation, thus resulting in a "soft landing" for the economy and financial markets. This could allow the Fed wiggle room to lower rates, prompting a return to investors chasing yield among lower credit quality issuers, and providing relief for many weaker issuers in primary markets as the need to face 2025 maturities kicks in later this year and early 2024.

In our pessimistic scenario, we forecast the default rate could rise to 6.25%.   For now, we assume the upcoming recession will be relatively short-lived and not deep. But, if a more widespread, deeper, or longer downturn were to occur, defaults could rise materially from their current lows. Inflation remaining higher than the Fed's roughly 2% target 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 be challenging, especially for the historically high proportion of issuers rated 'B-' and 'CCC' to 'C', many of which are in consumer-facing sectors.



Positive Economic Data Offset By Extended Period Of Rising Rates

Economic growth has arguably surprised to the upside for several quarters, and preliminary estimates for the second quarter of 2023 are also showing growth (the Atlanta Fed's GDP Now estimate is for 2.7% growth as of May 8). Recent inflation readings for April continue to show declines, however, only a marginal decline in the headline CPI figure (4.9% through April, from 5% through March). In addition, unemployment--often associated with rising defaults--remains low at 3.4%.

This ongoing resilience by the U.S. economy has caused our economists to push out and moderate their expectations for a recession ahead (see: "Economic Outlook U.S. Q2 2023: Still Resilient, Downside Risks Rise", Mar. 27, 2023). Meanwhile, the Fed continues to raise interest rates, which has caused floating-rate benchmark rates to rise in lock-step (see chart 2). Both three-month Libor and secured overnight finance rate (SOFR) have been rising quickly since the start of 2022, and a majority of the corporate debt we rate at the lowest rating levels ('B-' and lower) is in leveraged loans which use these rates as their basis. Conversely, longer-dated fixed-rate yields on bonds have been moving around a small range for the last six months, perhaps indicating bond markets have reached their new, post-pandemic rate levels. Indeed, high-yield bond issuance has come back to more typical levels recently, while leveraged loans remain well below typical trends since rate hikes began.

Chart 2


For now, we feel near-term refinancing risk is rather limited, particularly given the very small amount of fixed-rate debt coming due through 2024 in the riskiest ratings (see chart 3). Through 2024, only $20.4 billion of debt rated 'B-' or lower with fixed interest rates is coming due, limiting the amount of speculative-grade debt facing a potential sticker-shock from materially higher interest rates in the near-term. However, fully $580 billion of floating-rate debt rated 'B- and lower is currently being serviced, meaning that more than half a trillion dollars-worth of debt at the riskiest rating levels has been subjected to quickly rising interest rates on a regular basis for more than a year. Much of this debt is concentrated in the top four sectors, all of which have arguably higher than average default risk: high tech has the highest proportion of issuers at 'B-' or lower, healthcare has had a recent rise in both downgrades and defaults, and media and entertainment and consumer products are two sectors that both rely on personal consumption, and are the largest contributors to our 'CCC/C' population.

Chart 3


Given economic stress ahead is expected to be somewhat limited, and that markets still believe the Fed will pivot on interest rates (again), many firms with falling cash flows and rising expenses may opt to engage in distressed exchanges or out-of-court restructurings. These are already the leading cause of default in the U.S. through April (35%) and were a majority of defaults in both 2021 and 2022. Distressed exchanges are arguably linked with the length and severity of any expected downturn. They often rise after other forms of default during periods of more severe stress like the global financial crisis or the recent pandemic. On the other hand, during more unique periods of stress like the collapse in commodity prices that began in the second-half of 2014, distressed exchanges led more conventional defaults (see chart 4).

These trends make intuitive sense: if a deep or prolonged downturn is anticipated, it is more likely that a firm in financial distress will ultimately be unable to continue, prompting bankruptcy. If however, the economic downturn is expected to be short-lived or mild, a less-costly restructuring may be enough to ease the borrower through a rough patch. Given our economists' expectations for a short and shallow recession, combined with market expectations for interest rates to start declining this year, and given the higher proportion of private equity and debt sponsors (which we estimate to be at about 75% of our spec-grade universe), it is likely that distressed exchanges will continue to lead defaults ahead.

Chart 4


Markets Wobble On Bank Stress; Remain Buoyant

The speculative-grade spread has held in at tight levels so far in 2023, despite bank sector turmoil in March. Credit pricing appears to reflect expectations for easier financial conditions in the second half of the year, with Fed funds futures pricing in cuts to the Fed funds rate beginning in September. Even so, we continue to expect credit conditions will remain restrictive over the next 12 months, and we see credit risk building as speculative-grade debt maturities rise in 2024 and 2025.

Credit spreads 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 5). At 415 basis points (bps) in March, the speculative-grade bond spread implied a 2.4% default rate by March 2024.

Chart 5


The speculative-grade spread is a good indicator of broad market stress, but we believe the corporate distress ratio is a more targeted indicator of future defaults across all points in credit and economic cycles. The distress ratio has proved to be an especially good predictor of defaults during periods with more accommodative funding. As a leading indicator, the distress ratio shows a similar relationship to the speculative-grade spread, but with a nine-month lead time as opposed to one year. The 8.8% distress ratio in April would correspond to a 2.8% default rate for January 2024 (see chart 6).

Chart 6


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 March, the speculative-grade bond spread in the U.S. was about 233 bps below the implied level (see chart 7). Some spread widening occurred after the collapse of two regional banks in the U.S. in mid-March, but this was largely targeted at the bank sector rather than a market-wide repricing of risk. As of April 30, the speculative-grade spread was 408 bps, roughly in line with where it began the year, after two months of tightening at the outset of 2023. Market volatility is still relatively low, particularly compared with 2022 (which supports a lower spread estimate), but economic activity is still slowing, particularly in the manufacturing sector, which supports a wider estimated spread. The net effect seems to indicate that current spreads are historically optimistic given similar circumstances in the past.

Chart 7


We Expect Credit Conditions To Remain Tight Over The Next 12 Months

We believe liquidity is the key risk to monitor this year, primary market activity, balance-sheet liquidity, and cash flow. Our rating actions since second-half 2022 show that momentum in credit deterioration is slowly building, and we have noted an uptick in liquidity deterioration among weaker-rated speculative-grade issuers.

Credit risk will continue to build over the next 12 months. The speculative-grade maturity wall grows in 2024, and is notably higher in 2025. Credit conditions will remain restrictive as refinancing risk rise entering 2024.

Speculative-grade yields have room to rise further. Market expectations for a Fed pivot this year remain priced in--despite guidance from the Federal Reserve consistently to the contrary. Whether rate expectations in market pricing adjust or weakening economic conditions warrant a pivot, the divergence between market pricing and Fed guidance points to a pickup in volatility.

Table 1

Mixed signals muddy the outlook
U.S. unemployment rate (%) Fed survey on lending conditions Industrial production (%chg. YoY) Slope of the yield Ccrve (10yr - 3m; bps) Corporate profits (nonfinancial; %chg. YoY) Equity market volatility (VIX) High yield spreads (bps) Interest burden (%) S&P distress ratio (%) S&P Global U.S. SG neg. bias (%) Ratio of downgrades to total rating actions* (%) Proportion of SG initial issuer ratings B- or lower (%) U.S. weakest links (#)
2019Q1 3.8 2.8 0.6 1 4.2 13.7 385 9.0 7.0 19.8 73.3 40.8 150
2019Q2 3.6 -4.2 -0.7 -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 -5.0 59 -4.1 53.5 850 9.0 35.2 37.1 89.9 54.8 316
2020Q2 11 41.5 -10.7 50 -17.5 30.4 636 9.2 12.7 52.4 94.6 72.1 429
2020Q3 7.9 71.2 -6.5 59 1.1 26.4 577 7.9 9.5 47.5 63.3 45.5 390
2020Q4 6.7 37.7 -3.8 84 -4.9 22.8 434 8.1 5.0 40.4 50.0 57.9 339
2021Q1 6.1 5.5 0.5 171 13.8 19.4 391 7.6 3.4 29.9 30.6 49.5 265
2021Q2 5.9 -15.1 8.7 140 37.5 15.8 357 7.2 2.3 20.6 24.1 42.2 191
2021Q3 4.8 -32.4 3.4 148 14.0 23.1 357 7.2 2.6 16.0 27.3 36.5 155
2021Q4 3.9 -18.2 3.0 146 20.7 17.2 351 7.1 2.6 14.1 34.5 33.3 131
2022Q1 3.6 -14.5 4.4 180 6.1 20.6 346 7.1 2.7 12.5 36.0 30.9 121
2022Q2 3.6 -1.5 3.2 126 5.0 28.7 546 6.6 8.3 13.8 46.9 46.3 127
2022Q3 3.5 24.2 4.5 50 3.5 31.6 481 6.1 7.9 16.7 57.8 52.6 144
2022Q4 3.5 39.1 0.58491763 -54 1.6 21.7 415 5.6 7.3 19.1 76.0 71.4 195
2023Q1 3.5 44.8 0.534553758 -137 18.7 415 9.2 20.2 61.0 75.0 203
YoY--Year-on-year. Q--Quarter. CHYA--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. Source: 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; S&P Global Ratings Credit Research & Insights.

Negative Rating Pressure Is Building As Credit Headwinds Persist

Negative rating actions have gained momentum. Speculative-grade credit quality could remain somewhat resilient in a shallow recession, but the buildup of 'B-' rated issuers adds to downside risk--this could contribute to sharper deterioration in our speculative-grade ratings (see chart 8).

Chart 8


In the first quarter, just three sectors had a positive net bias, and all but three sectors had negative net rating actions (see chart).

Chart 9


There are five sectors that stand out in the current environment. Combined, these five sectors account for nearly 77% of speculative-grade issuers with a negative bias and 83% of weakest links.

Some consumer/service issuers are reporting weak operating results. Inflation, supply-chain tightness, and a challenging macroeconomy are weighing on issuer credit quality.

Weaker macroeconomic conditions are expected 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 amid continued normal social activities and strong spending on services.

Within the aerospace/automotive/capital goods/metal sector, capital goods and automotive issuers are being affected by persistent of inflationary pressure and supply-chain disruptions.

Rising interest expense is pressuring issuer cashflows, specifically issuers that rely on the leveraged loan market for capital. We are already noting evidence of this for some highly leveraged issuers in high technology and healthcare who are also contending with a challenging macroeconomy 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 6.6% in the 12 months ended March 2023, 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 March 2024 (31 defaults in the trailing 12 months) in our optimistic scenario and 6.25% (115 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;
Jon Palmer, CFA, Austin 212 438 1989;
Research Contributor:Shripati Pranshu, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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