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Default, Transition, and Recovery: Resilient Growth, Resilient Yields, And Resilient Defaults To Bring The U.S. Speculative-Grade Corporate Default Rate To 4.5% By March 2025

COMMENTS

Credit Trends: U.S. Corporate Bond Yields As Of May 22, 2024

COMMENTS

Default, Transition, and Recovery: The European Speculative-Grade Default Rate Should Level Out At 3.75% By March 2025

COMMENTS

Credit Trends: U.S. Corporate Bond Yields As Of May 15, 2024

COMMENTS

Default, Transition, and Recovery: Monthly Default Tally Reached Four-Year High In April


Default, Transition, and Recovery: Resilient Growth, Resilient Yields, And Resilient Defaults To Bring The U.S. Speculative-Grade Corporate Default Rate To 4.5% By March 2025

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S&P Global Ratings Credit Research & Insights expects the U.S. trailing-12-month speculative-grade corporate default rate to fall slightly to 4.5% by March 2025, from 4.8% in March 2024 (see chart 1).  This assumes defaults will peak either later in the second quarter or, more likely, the third quarter of this year.

Interest rates will likely remain higher for longer given stubborn inflation. We still expect rates to ease, but now much later in the year than we previously expected. Positively, economic growth and corporate profits remain broadly healthy, and many issuers recently refinanced upcoming maturities, easing near-term pressure. Market sentiment has also been supportive, providing liquidity where needed.

Chart 1

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In our optimistic scenario, we forecast the default rate could fall to 3%.  In this scenario, economic growth would steadily surprise to the upside alongside falling inflation and interest rates. The last time the U.S. saw a "soft landing" like this was in the mid-1990s, when the default rate peaked at 4%--largely in line with the default rate through March.

In this scenario, interest rates would fall faster and earlier than the fourth quarter, but admittedly time is running thin for this to occur. Risks remain in the latter part of the year, but if these should pass without much volatility, current conditions could help to push the default rate down faster than in our base case.

In our pessimistic scenario, we forecast the default rate could rise to 6.25%.  In this scenario, economic growth would slow to a crawl or enter recession (though our economists don't currently expect a recession). While we anticipate core inflation to fall this year, this has taken longer than it did for inflation to rise, keeping the Federal Reserve from lowering policy rates any time soon.

The prolonged effect of the highest nonrecessionary market interest rates since before the financial crisis poses the biggest challenge to a still large population of issuers in the 'B-' and 'CCC' categories. The balance between interest rates, economic growth, and corporate profitability could deteriorate later this year as higher borrowing costs on the wave of recently refinanced debt chip away at cash flow.

The Great Rate Games

Given persistent inflation, higher interest rates are clearly here to stay for a while. Markets started the year expecting six rate cuts by the Fed, but as time has passed, that has dwindled to two. For speculative-grade issuers, floating-rate benchmarks and market yields tend to follow policy rates very closely, but fixed-rate bond yields were arguably falling ahead of expected cuts (see chart 2).

Current market yields could either remain in place or rise to recalibrate to now higher-for-longer policy rates. And though bullish sentiment has allowed for a surge in speculative-grade debt issuance in 2024, issuance will likely slow as the year goes on.

Chart 2

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Despite rates likely remaining higher for longer, market enthusiasm from fourth-quarter 2023 and first-quarter 2024 opened a window of opportunity for speculative-grade issuers to come to primary markets at a healthy clip, with issuance through April finishing only behind the same period of 2021 (see chart 3).

Although robust, the vast majority of recent issuance was used for refinancing, rather than for more growth-oriented ends such as capital expenditure or mergers and acquisitions. While this relieves near-term refinancing pressure, it also resets a large amount of debt to current, higher yields.

Chart 3

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With any easing of borrowing costs pushed out to later this year, it will take sustained economic growth and corporate profits to see defaults ease significantly in the next 12 months. Many observable credit trends have improved slightly in recent months (fewer downgrades, slightly improving negative bias, a slightly stronger rating distribution), but many of the lowest-rated issuers are in consumer-reliant sectors such as media and entertainment, consumer products, and retail.

These sectors may suffer from consumers pulling back on spending as higher rates limit their available funds. Cumulative excess savings from pandemic supports have finally disappeared, and stress is already showing up in rising delinquency rates (see chart 4)--particularly for credit cards and among younger borrowers. Delinquencies may continue to rise as lower pent-up savings coincide with resuming student loan payments.

Chart 4

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Bond Spreads Dip To Record Lows…

Speculative-grade bond spreads fell to a new all-time low of 230 basis points (bps) on May 7, reflecting increased optimism and risk appetite among investors given healthy economic growth and corporate profits. Credit spreads can majorly contribute 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 5). At 261 bps in March, the average speculative-grade bond spread implies a much lower default rate by March 2025. Even loan spreads--which ended March at 463 bps--remain relatively favorable given the large percentage of leveraged loans in the U.S. rated 'B' and 'B-'.

Chart 5

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That said, the corporate distress ratio is a more targeted indicator of future defaults across credit and economic cycles, especially during periods with higher rates. The distress ratio indicates future defaults with a roughly nine-month lead. The 4.9% distress ratio in March would roughly correspond to a 2.4% default rate for December 2024 (see chart 6).

Chart 6

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…But May Still Be Too Optimistic

Using the CBOE Volatility Index (VIX), the ISM Purchasing Managers' Index, and components of the money supply, we estimate that in March, the average speculative-grade bond spread in the U.S. was about 205 bps below the implied level (see chart 7).

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 7

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Bullish Market Conditions And Stabilizing Credit Indicators

Market signals are bullish, but many other credit and economic indicators remain more challenging (see table 1). Bank lending conditions continue to tighten, the yield curve remains inverted after over a year, and the number of weakest links is still elevated. (Weakest links are issuers rated 'B-' or lower by S&P Global Ratings with negative outlooks or ratings on CreditWatch with negative implications.)

Credit conditions appear to be stabilizing recently, but defaults are above the long-term average. And downside risks remain: we now expect rates to stay higher for longer, consumer spending and credit trends are deteriorating, and geopolitical risks have been rising--all of which could quickly turn markets risk averse.

Table 1

Markets remain largely positive, credit stabilizes
U.S. unemployment rate (%) Fed survey on lending conditions Industrial production (%chg. YoY) Slope of the yield curve (10yr - 3m; bps) Corporate profits (nonfinancial; %chg. YoY) Equity market volatility (VIX) High yield spreads (bps)
Q1 2019 3.8 2.8 0.6 1 4.7 13.7 385.2
Q2 2019 3.6 (4.2) (0.7) (12) 3.7 15.1 415.6
Q3 2019 3.5 (2.8) (1.5) (20) 7.2 16.2 434.1
Q4 2019 3.6 5.4 (2.0) 37 4.8 13.8 399.7
Q1 2020 4.4 0.0 (5.0) 59 (6.2) 53.5 850.2
Q2 2020 11.1 41.5 (10.7) 50 (16.9) 30.4 635.9
Q3 2020 7.8 71.2 (6.5) 59 7.5 26.4 576.9
Q4 2020 6.7 37.7 (3.8) 84 (2.8) 22.8 434.4
Q1 2021 6.0 5.5 0.5 171 20.4 19.4 390.8
Q2 2021 5.9 (15.1) 8.7 140 45.5 15.8 357.3
Q3 2021 4.8 (32.4) 3.4 148 7.0 23.1 357.1
Q4 2021 3.9 (18.2) 3.0 146 18.0 17.2 350.8
Q1 2022 3.6 (14.5) 4.4 180 4.0 20.6 346.1
Q2 2022 3.6 (1.5) 3.2 126 4.5 28.7 546.1
Q3 2022 3.5 24.2 4.5 50 7.9 31.6 481.4
Q4 2022 3.5 39.1 0.6 (54) 7.1 21.7 414.8
Q1 2023 3.5 44.8 0.2 (137) 3.6 18.7 414.9
Q2 2023 3.6 46.0 (0.4) (162) (4.1) 13.6 355.5
Q3 2023 3.8 50.8 (0.2) (96) (2.1) 17.5 344.0
Q4 2023 3.7 33.9 1.1 (152) 3.8 12.5 297.9
Q1 2024 3.8 14.5 (0.0) (126) 13.0 247.1
NA CDX (bps) Interest burden (%) S&P Global Ratings distress ratio (%) S&P Global Ratings U.S. speculative-grade neg. bias (%) Ratio of downgrades to total rating actions* (%) Proportion of speculative-grade initial issuer ratings B- or lower (%) U.S. weakest links (#)
Q1 2019 349 11.3 7.0 19.8 73.3 40.8 150
Q2 2019 324 11.2 6.8 20.3 67.3 41.7 167
Q3 2019 350 10.8 7.6 21.4 81.5 37.7 178
Q4 2019 281 10.4 7.5 23.2 81.0 39.6 195
Q1 2020 658 10.4 35.2 37.1 89.9 54.8 316
Q2 2020 516 10.2 12.7 52.4 94.6 72.1 429
Q3 2020 409 8.3 9.5 47.5 63.3 46.2 390
Q4 2020 293 8.5 5.0 40.4 50.0 57.9 339
Q1 2021 308 7.9 3.4 29.9 30.6 49.5 265
Q2 2021 274 7.3 2.3 20.6 24.1 42.2 191
Q3 2021 302 7.3 2.6 16.0 27.3 36.5 155
Q4 2021 292 7.2 2.6 14.1 34.5 33.3 131
Q1 2022 376 6.9 2.7 12.5 36.0 30.4 121
Q2 2022 578 6.4 9.2 13.8 46.9 45.5 127
Q3 2022 609 6.0 6.0 16.7 57.8 50.0 144
Q4 2022 485 5.7 7.9 19.1 76.0 71.4 195
Q1 2023 463 5.5 9.2 20.2 61.0 75.0 299
Q2 2023 430 4.6 7.2 19.8 63.4 56.7 207
Q3 2023 481 3.8 6.5 21.7 60.2 38.8 229
Q4 2023 356 3.7 5.9 21.7 66.0 48.6 228
Q1 2024 329 4.9 20.8 52.0 34.3 212
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. 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 Credit Research & Insights.

Negative Rating Momentum Slows But Unevenly

Negative rating actions have remained moderate for over a year, but we expect them to increase given the still elevated negative bias among issuers rated 'B-' and below. This could contribute to a sharper deterioration in our speculative-grade ratings if rates remain high for an extended period (see chart 8). But given currently modest negative rating momentum, a spike in defaults appears unlikely in the near term.

Chart 8

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In the first quarter, just three sectors had a positive net bias, but seven (of 13) had negative net rating actions (see chart 9). (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.).

Chart 9

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Some of the largest sectors have had the most negative credit developments in the last 12 months: consumer/service; health care; and leisure.

The consumer products sector had the highest number of weakest links at the end of March, with 46. Consumer-reliant sectors accounted for 51% of defaults in the U.S. in 2023, and the state of the consumer could come under pressure this year . This sector and the consumer/service sector will likely continue to face strained cash flow given higher-for-longer interest rates.

The health care sector had the second-highest number of weakest links in March, with 38. This sector is more vulnerable to cash flow disruptions amid higher interest rates and inflation given its larger share of weaker-rated issuers (those rated 'B-' and below) with floating-rate debt. These highly leveraged companies have been struggling to generate adequate sustained free cash flow, with particular focus on labor costs, given persistent shortages of health care personnel.

Media and entertainment had the third-highest number of weakest links in March and led defaults in the U.S. in 2023. Here again, refinancing and elevated financing costs remain the key risks. However, like the two prior sectors, issuers in this sector refinanced large amounts of debt in the first four months of 2024, helping to ease near-term risk.

As downgrades of speculative-grade issuers have increased since the start of the pandemic, the share of issuers rated 'CCC' to 'C' has grown (see chart 10). However, with the increase in defaults over 2023, the proportion of these issuers has started to decline in the last six months. These lowest-rated issuers have historically had a much higher default rate, and we expect them to remain stressed over the next few quarters.

Chart 10

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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 3% in March 2025 (50 defaults in the trailing 12 months) in our optimistic scenario and 6.25% (104 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.

S&P Global Ratings Credit Research & Insights:Nick W Kraemer, FRM, New York + 1 (212) 438 1698;
nick.kraemer@spglobal.com
Research Contributor:Vaishali Singh, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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