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CreditWeek: Will Holiday Shopping Deliver A Gift To Retailers In The U.S. And Europe?


China Securitization: ABS And RMBS Tracker October 2023


Asia-Pacific Transport Infrastructure 2024 Outlook: Capex Is Becoming A Credit Driver


Credit Trends: U.S. Corporate Bond Yields As Of Nov. 22, 2023


Table Of Contents: S&P Global Ratings Credit Rating Models

CreditWeek: Will Holiday Shopping Deliver A Gift To Retailers In The U.S. And Europe?


S&P Global Ratings Credit Research & Insights expects the U.S. trailing-12-month speculative-grade corporate default rate to reach 5% by September 2024, from 4.1% in September 2023 (see chart 1).   In our base case, we expect defaults to continue rising as corporate entities grapple with higher interest rates for what might be a longer haul ahead. Rising rates will be compounded by slower growth ahead, straining many firms at the lowest ratings already showing negative cash flow to debt.

The pace of firms downgraded into the 'CCC/C' category remains elevated, and their challenges are mounting quickly. Of the 210 issuers rated 'CCC/C', many currently have negative free-operating cash flow to debt. When combined with a slowing economy, rising rates, and particularly thin primary markets this year for this rating category, these firms are particularly vulnerable.

Chart 1


In our optimistic scenario, we forecast the default rate could fall to 3.25%.   In this scenario, economic resilience would continue alongside falling inflation, resulting in a "soft landing" for the economy and financial markets. The last time the U.S. saw a soft landing was in the mid-1990s, which saw a peak default rate of 4%--roughly the same level through September. This scenario would give the Federal Reserve space to lower rates prior to mid-2024. The earlier interest rates decline, the more debt in need of refinancing that can avoid today's elevated interest rates. Although playing chicken with interest rates will only save borrowers so much and comes with plenty of risks.

In our pessimistic scenario, we forecast the default rate could rise to 7%.   In this scenario, the U.S. would enter a recession, slowing revenues further. If this is accompanied by sticky or higher core inflation, this situation could be made worse for borrowers if the Fed keeps rates elevated or engages in further increases.

The weakest borrowers are already facing cash flow challenges. In this scenario, these challenges will increase and infect more borrowers. This is of particular concern for the many issuers rated 'B-' and below, particularly those with a higher dependence on sustained, strong consumer spending.



The Stretched Consumer Remains Key

Since the second half of 2020, the U.S. economy has demonstrated a consistent pace of (often unexpected) resilience. And much of that can be attributable to supportive consumer spending, which in turn has been supported by built-up savings on the part of households as a result of the large pandemic-related supports from the federal government (see chart 2). But with a split government and elevated Treasury yields, which may persist for some time, taking up more federal expenditures, we don't expect to see any further rounds of consumer-supportive stimulus ahead.

Chart 2


And it is these consumer-reliant sectors such as media and entertainment; consumer products; and retail/restaurants that have both contributed the most to the default tally this year, as well as rank at the top of sectors contributing the most to the 'CCC/C' population of issuers (see chart 3). Many issuers within the top three sectors (consumer products, media and entertainment, and health care) also have the largest shares of 'CCC/C' issuers with negative cash flow to debt ratios. High debt levels, largely consisting of floating-rate loans have been, and will continue to present, funding challenges as a jump in maturing debt in 2025 becomes a priority next year amid what we believe will be persistently higher rates.

Chart 3


Consumers may be seeing falling savings rates to their disposable income, but the very high rates during 2020-2021 mean there remains a stock of accumulated savings that likely still has some runway. However, at some point soon this will run out, and even now it is likely largely stocked away among the higher-earning households.

Markets Remain Largely Optimistic

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 (see chart 4). At 344 basis points (bps) in September, the speculative-grade bond spread implies a 1.88% default rate by September 2024. Even loan spreads—which were 513 bps at the end of September—are still relatively favorable given the large percentage of leveraged loans in the U.S. rated 'B' and 'B-'.

Chart 4


The speculative-grade spread is a good indicator of broad market stress, but the corporate distress ratio is a more targeted indicator of future defaults across credit and economic cycles, especially during periods with more accommodative funding. The distress ratio shows a similar relationship to the speculative-grade spread, but with a nine-month lead. The 7% distress ratio in October would correspond to a 2.6% default rate for July 2024 (see chart 5).

Chart 5


Bond Spreads May Be Too Optimistic

Using the CBOE Volatility Index (VIX), the Institute for Supply Management (ISM) Purchasing Managers' Index, and components of the money supply, we estimate that at the end of September, the speculative-grade bond spread in the U.S. was about 213 bps below the implied level (see chart 6).

Market volatility is still relatively low, particularly compared with 2022, which supports a lower spread estimate. On the other hand, certain economic activity continues to slow, 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 past circumstances.

Chart 6


We Expect Credit Conditions To Become More Strained Over The Next 12 Months

Market signals may appear rather bullish recently, but many other credit and economic indicators have been deteriorating, if slowly (see table 1). Bank lending conditions continue to tighten, the yield curve remains inverted after over a year, corporate profits declined last quarter, and the ratio of downgrades and weakest links remain elevated. (Weakest links are issuers rated 'B-' or lower by S&P Global Ratings with negative outlooks or ratings on CreditWatch with negative implications.)

We expect credit risk to build over the next 12 months. Speculative-grade maturities will grow in 2024 and are notably higher in 2025. Credit conditions will remain restrictive as refinancing risk climbs entering 2024.

Speculative-grade yields have room to rise further, particularly as Treasury yields remain high. Meanwhile, markets don't expect the Fed to cut rates until around next June, implying little relief for borrowers in the near term.

Table 1

Mixed Signals, But Leaning Negative
U.S. unemployment rate (%) Fed survey on lending cond. Industrial prod. (% chg YoY) Slope of yield curve (10 year - 3 month; bps) Corporate profits (nonfin.; % chg YoY) Equity Market Volatility (VIX) High-yield spreads (bps) NA CDX Interest burden (%) S&P Global distress ratio (%) S&P Global U.S. spec-grade neg. bias (%) Ratio of downgrades to total rating actions* (%) Proportion of spec-grade initial issuer ratings 'B-' or lower (%) U.S. weakest links (no.)
2019Q1 3.8 2.8 0.6 1.0 4.2 13.7 385.2 349.3 9.0 7.0 19.8 73.3 40.8 150
2019Q2 3.6 (4.2) (0.7) (12.0) 7.2 15.1 415.6 324.2 9.0 6.8 20.3 67.3 40.8 167
2019Q3 3.5 (2.8) (1.5) (20.0) 5.0 16.2 434.1 350.2 9.0 7.6 21.3 81.5 37.7 178
2019Q4 3.6 5.4 (2.0) 37.0 1.7 13.8 399.7 280.5 8.8 7.5 23.2 81.0 39.6 195
2020Q1 4.4 0.0 (5.0) 59.0 (4.1) 53.5 850.2 657.9 9.0 35.2 37.1 89.9 54.8 316
2020Q2 11.0 41.5 (10.7) 50.0 (17.5) 30.4 635.9 516.4 9.2 12.7 52.4 94.6 72.1 429
2020Q3 7.9 71.2 (6.5) 59.0 1.1 26.4 576.9 409.3 7.9 9.5 47.5 63.3 45.5 390
2020Q4 6.7 37.7 (3.8) 84.0 (4.9) 22.8 434.4 293.2 8.1 5.0 40.4 50.0 57.9 339
2021Q1 6.1 5.5 0.5 171.0 13.8 19.4 390.8 308.0 7.6 3.4 29.9 30.6 49.5 265
2021Q2 5.9 (15.1) 8.7 140.0 37.5 15.8 357.3 273.5 7.2 2.3 20.6 24.1 42.2 191
2021Q3 4.8 (32.4) 3.4 148.0 14.0 23.1 357.1 301.9 7.2 2.6 16.0 27.3 36.5 155
2021Q4 3.9 (18.2) 3.0 146.0 20.7 17.2 350.8 291.9 7.1 2.6 14.1 34.5 33.3 131
2022Q1 3.6 (14.5) 4.4 180.0 6.1 20.6 346.1 375.5 7.1 2.7 12.5 36.0 30.9 121
2022Q2 3.6 (1.5) 3.2 126.0 5.0 28.7 546.1 578.4 6.6 8.3 13.8 46.9 46.3 127
2022Q3 3.5 24.2 4.5 50.0 3.5 31.6 481.4 608.7 6.1 7.9 16.7 57.8 52.6 144
2022Q4 3.5 39.1 0.6 (54.0) 1.6 21.7 414.8 484.9 5.6 7.3 19.1 76.0 71.4 195
2023Q1 3.5 44.8 0.5 (137.0) (1.9) 18.7 414.9 463.4 5.2 9.2 20.2 61.0 75.0 203
2023Q2 3.6 46.0 (0.4) (134.0) (1.0) 15.9 356.0 429.7 4.6 7.2 19.8 65.3 56.7 207
2023Q3 3.8 50.8 0.3 (72.0) 20.4 344.0 480.6 6.5 21.7 62.0 37.5 229
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; and S&P Global Ratings Credit Research & Insights.

Negative Rating Pressure Has Been Slowly Building

Negative rating actions have remained moderate, but we expect them to increase. Speculative-grade credit quality has proven largely resilient thus far, but the buildup of 'B-' rated issuers, many with significant floating-rate debt, adds to downside risk. This could contribute to a sharper deterioration in our speculative-grade ratings if rates remain high (see chart 7).

Chart 7


In the third quarter, just three sectors had a positive net bias, and all but three sectors had negative net rating actions (see chart 8). (We define net bias as the share of issuers with ratings that have positive bias, meaning those with positive outlooks or ratings on CreditWatch positive, minus the share of ratings that have negative bias.)


Four sectors combined account for over 71% of speculative-grade issuers with a negative bias and 74% of weakest links.

The consumer/service sector leads in terms of weakest links through Sept. 30. The state of the consumer is the biggest wild card now. While inflation has tempered, it has ticked upwards in recent months. While the Fed seems to have paused additional rate hikes as it waits for additional data to come through, the discussion to raise rates further to cool the economy remains open, which could lead to higher unemployment. The sector may also face strained cash flow given higher for longer interest rates.

The health care sector has also exhibited weakness through the third quarter, with 40 issuers on the U.S. weakest link tally. Elevated labor and material costs, coupled with staff shortages, are weighing on margins and cash flow. Further, increased regulatory scrutiny coupled with the high interest rate environment has largely slowed mergers and acquisitions. As such, partnerships or smaller-scale deals have increased for growth opportunities. The sector is also more vulnerable to cash flow disruptions amid higher interest rates given its larger share of weaker-rated issuers (those rated 'B-' and below) with floating rate debt.

Media and entertainment had the third-highest number of weakest links and potential downgrades through the third quarter. (Potential downgrades are issuers rated by S&P Global Ratings with a negative outlook or a rating on CreditWatch negative.) Despite resilient consumer spending in the U.S., advertisers have been hesitant to spend given macroeconomic uncertainty and the potential for a pullback on consumer spending.

Higher for longer interest rates could deplete consumer savings, weakening discretionary spending, such as streaming subscriptions. The writer's strike resolution in the third quarter bodes well for the sector, with the already fragile media and entertainment market no longer in desperation for new content. That said, there is divergence in the sector, with credit quality for some issuers underpinned by improved fundamentals amid the continued normalization of social activities and strong spending on services.

Chart 9


Chart 10


As downgrades of speculative-grade issuers have increased since the pandemic, the share of issuers rated 'CCC' to 'C' has grown (see chart 11). In fact, the downgrade rate from the 'B' category has risen sharply, to 8% in the 12 months ended September 2023, from a low of 1.5% at the end of 2021. These lowest-rated issuers have historically had a much higher default rate, and we expect them to see greater stress over the next few quarters.

Chart 11


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 3.25% in September 2024 (56 defaults in the trailing 12 months) in our optimistic scenario and 7% (121 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;
Brenden J Kugle, Englewood + 1 (303) 721 4619;
Research Contributor:Shripati Pranshu, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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