Chart 1

S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to increase to 3.4% by June 2020 from 2.36% as of June 2019 (see chart 1).  A prolonged period of episodic financial market stress, mixed economic signals, and highly unpredictable political conditions globally has led the Federal Reserve and European Central Bank to lower interest rates as well as provide some measure of quantitative easing. This move should help keep corporate borrowing costs stable, but the positive effects may be limited, given that markets seem to have already priced in several more rate cuts. Speculative-grade borrowing costs have been more volatile over the past six months, particularly for lower-rated issuers. Economic and financial indicators have started signaling that borrowing costs could rise further in the months ahead or that they are currently lower than what the macro backdrop would seem to indicate.

In our pessimistic scenario, we forecast the default rate will rise to 5%.  In this scenario, we assume further deterioration in the U.S.-China trade dispute, resulting in the U.S. expanding the list of Chinese goods subject to 25% tariffs and taking stronger actions against intellectual property violations, prompting retaliation from China toward U.S. firms. This escalation would result in decreased trade, increased financial market volatility, and a hit to the real economy as the situation affects the still-resilient U.S. consumer. We also assume in this scenario that the prolonged inverted yield curve will indeed trigger a recession and a double-digit default rate at some point within the next 24 months.

In our optimistic scenario, we forecast the default rate will fall slightly, to 2.3%.  We assume an improved trade situation between the U.S. and China in this scenario, with U.S. tariffs on Chinese imports falling back to 10% and remaining limited to the current list of goods totaling $250 billion. We would also assume in this scenario that the Fed would cut interest rates to an even greater extent, forcing investors to once again hunt for yield among the riskiest borrowers. An improvement in the trade dispute would likely spare consumers and the high tech industry from higher costs. Given that the high tech sector is both highly exposed to the next round of proposed tariffs and holds a large percentage of the debt maturing over the next 12 months, a deescalation of the trade dispute would greatly benefit this larger sector within the speculative-grade segment (rated 'BB+' or lower).

Despite Strong Consumer Sentiment, Consumer Sectors Are Likely To Lead Near-Term Defaults

As lending conditions have been favorable over the past 10 years, defaults have remained muted across most sectors outside of energy and natural resources, which saw a spike in 2016, largely as a consequence of dramatically falling oil prices. More recently, however, defaults have become more frequent in the consumer services sector, which includes consumer products and retail and restaurants. These sectors have faced difficulties in recent years as consumers shift more of their purchases online and increased price discovery squeezes margins.

Together, energy and consumer services account for 45.6% of all U.S. firms currently rated 'CCC+' or lower by S&P Global Ratings. Retail sales are still growing steadily, but at a slower pace relative to mid-2018, while consumer confidence remains just below its multiyear high reached in October. Meanwhile, oil prices have fallen recently, with a barrel of West Texas Intermediate finishing at $54.6 on Aug. 5, from a recent high of $66.2 on April 23. Although falling, the current price is in line with S&P Global Ratings' price assumptions (see "S&P Global Ratings Lowered Its Henry Hub Natural Gas Price Assumption For The Rest of 2019 And For 2020, 2021; Long-Term U.S. Natural Gas, Canadian AECO, And Crude Oil Price Assumptions Unchanged," July 29, 2019).

These two sectors have accounted for the majority of defaults in recent years. In fact, excluding the energy and natural resources and consumer services sectors, the default rate was only 1.46% in the 12 months ended June 30 (see chart 2).

Chart 2

Ultimately, most sectors within the speculative-grade segment are likely to see increased downgrades over the next 12 months, and typically downgrade momentum precedes defaults. Chart 3 presents net rating actions (upgrades minus downgrades, as a proportion of the issuer base) over the prior 12 months against the net rating bias (current positive bias, or the proportion of issuers with positive outlooks or ratings on CreditWatch with positive implications, minus current negative bias) by sector.

Those sectors below the 45-degree line have a higher net negative bias than their recent net downgrade rate. In fact, only three (of 13) sectors are showing reduced downgrade potential relative to their recent experience. Some of the more stressed sectors are relatively small contributors to the overall speculative-grade population (telecommunications, utilities), but the consumer services sector is both the largest and has the highest current net negative bias, at -26%.

Chart 3

Funding Dynamics Have Shifted After Fed Statements

Speculative-grade firms have been changing their funding mix since the Fed started moving in a more accommodative direction this year. Generally, in anticipation of falling interest rates, leveraged loan volumes are far off from their 2018 year-to-date totals, while speculative-grade bonds are far outpacing last year's haul. Through July, speculative-grade bond issuance has reached $132.5 billion, up roughly 37% from $96.5 billion at the same point last year (see chart 4).

Chart 4

We expect a strong double-digit growth rate to continue through the remainder of the year, even if bond issuance slows to more typical historical trends. The high growth rate will likely persist simply because of the especially poor showing in the fourth quarter of last year. Slowing global growth and increasing geopolitical risks (and subsequent negative market reactions) remain threats, but at this point it seems safe to say speculative-grade bond issuance will surpass 2018 totals.

Meanwhile, leveraged loan issuance totaled $299 billion through July, compared with $428.6 billion over the same period in 2018. Bond issuance increased slightly, while leveraged loans have fallen back, largely as a result of the Fed pausing its rate hike trajectory (see chart 5).

Chart 5

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 2.3% in June 2020 (44 defaults in the trailing 12 months) in our optimistic scenario and 5% (95 defaults in the trailing 12 months) in our pessimistic scenario.

We determine our forecast based on a variety of factors, including our proprietary default model for the U.S. speculative-grade corporate bond market.  The main components of the model 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, defined as the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications).

In addition to our quantitative frameworks, we consider current market conditions and expectations.  Areas of focus can include equity and bond pricing trends and expectations, overall financing conditions, the current ratings mix, refunding needs, and both 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.

Default Signposts Reflect Budding Stress

Financial conditions have improved thus far in 2019 after getting off to a challenging start, but signs of stress remain. Industrial production has been slowing, while the proportion of lowest-rated issuers has been growing (see table 1). Additionally, many economic variables have seen downward revisions applied to the past five years or so. For example, the interest burden now reflects an upward trend (albeit slight) over the past few years, from a prior decline, while corporate profits in 2018--though still quite strong--have been revised to much lower growth rates relative to recent quarters.

We anticipate profits will be roughly flat to slightly negative in the second quarter, now that annual comparisons will no longer benefit from a reduced tax rate for corporations. Aftertax corporate profits contracted 2.9% on a year-over-year basis in the first quarter, in an expected cessation to the large gains seen in 2018, which was the first year under the new tax code. Thus far, about 77% of the S&P 500 constituents have reported second-quarter earnings, which in total are showing about a 1.7% increase from last year. That said, many sectors more heavily represented in the speculative-grade segment (communication services, energy, materials) have thus far reported significant declines, of over 10%.

The yield curve--which we define as the difference between the 10-year and three-month Treasury yields--has been inverted since May 23. More worrying, it has plunged deeper into negative territory, finishing Aug. 6 at -32 basis points (bps). Historically, an inverted yield curve has been considered a warning signal of a possible recession, with a lead time of about 18-24 months. An inversion has also preceded the last three times the default rate hit double digits.

Market volatility has generally been low in 2019, with the VIX finishing June at 15.1, from 25.4 at the end of 2018. That said, the escalation of the U.S.-China trade dispute in recent weeks saw the VIX hit a high of 24.6 on Aug. 5. Speculative-grade spreads, though still lower than at the end of 2018, have risen to 458 bps as of Aug. 7, from just below 400 bps as recently as July 16. The persistence of the trade dispute, now combined with slower economic growth expectations globally, will likely cause stronger negative market reactions to future events, as well as increased risk aversion toward the lower-rated segments of the speculative-grade population.

Lending conditions for loans remain supportive, but just barely. The Fed's second-quarter 2019 Senior Loan Officer Opinion Survey showed that on net, lending standards on commercial and industrial loans for large and medium-size firms eased in the second quarter. However, the net loosening was only 2.9%, down from a net loosening reading of 15.9% a year ago. Fears of a slowing economy and a reduction in lenders' risk appetite helped push the final reading to a broadly net-neutral level after some optimism in the early part of the year.

Nonetheless, consumers remain optimistic. At 3.7% in July, the unemployment rate is only slightly above its 50-year low of 3.6% reached in April and May. Wages and productivity are up, while inflation remains below 2%, and GDP growth came in at 2.1% in the second quarter, annualized. This has kept consumer sentiment (as measured by the Conference Board) near its all-time high reached in October. These factors are creating a rare combination of a strong economy and low interest and inflation rates, despite concerns about increased tariffs and disruptions to trade flows. S&P Global economists expect GDP growth to increase to 2.5% in 2019 but slow to 1.8% in 2020.

Although slowly rising, leverage for U.S. corporations has held remarkably steady in recent years. The U.S. corporate interest burden has averaged 10.7% since the first quarter of 2013, marking an unusually long period of relative stability. We define the interest burden as net interest payments as a percentage of our EBITDA profits proxy (the sum of profits, consumption of fixed capital, and net interest payments). Despite the large borrowings in recent years, low interest rates and strong corporate profits have kept interest payments (as a percentage of income) at historically modest levels. By this measure, leverage was at about 11.5% in the first quarter of 2019, up from the low of 9.8% in the fourth quarter of 2014.

Upcoming maturities appear manageable (see chart 6). Over the next 12 months, approximately $95 billion in outstanding speculative-grade debt is scheduled to mature, with $27 billion of that total rated 'B-' or lower. This is a historically low amount and well below the $431.6 billion in total bond and leveraged loan issuance over the 12 months ended July.

Chart 6

But Financial Markets Have Thus Far Been Optimistic

The relative risk of holding corporate bonds can be a major contributor to future defaults, since firms face pressure if they are unable to refinance maturing debt. One measure of this relative risk is the U.S. speculative-grade corporate spread, which reflects near-term market expectations for overall stress in the speculative-grade market. In broad terms, the speculative-grade spread is a good indicator of future defaults, based on a roughly one-year lead time (see chart 7). That said, at current spread levels, our baseline default rate forecast of 3.4% is above what the historical trend would suggest.

Chart 7

Given that spreads often reflect market liquidity and can be strong default indicators, it helps to get a sense of where they are relative to current economic and financial conditions. Bond spreads can reflect economic and financial market fundamentals but also investor sentiment, which can, at times, be fickle. Using a model based on the three broad measures of the VIX, the M1 money supply, and the Purchasing Managers' Index, we estimate that at the end of July, the speculative-grade bond spread in the U.S. was about 108 bps below where our model would suggest (see chart 8).

This gap also indicates that spreads are currently below where the larger economy and financial markets would suggest. Through most of the postrecession period, the spread was slightly higher than predicted. But the predicted level has exceeded the actual for 13 of the past 19 months--a phenomenon not seen since late 2007 through early 2008, right before spreads shot up past 1,000 bps, leading to a spike in the default rate roughly a year later. That said, during that time, the gap persisted for an extended period of three and a half years prior to a surge in spreads, and the magnitude of the gap was also larger than it is now.

Chart 8

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 feel a more targeted indicator of future defaults across all points in the credit and economic cycles is the corporate distress ratio (see chart 9).

Chart 9

The distress ratio (defined as the number of distressed credits, or speculative-grade issues with option-adjusted composite spreads of more than 1,000 bps relative to U.S. Treasuries, divided by the total number of speculative-grade issues) reflects market sentiment in much the same way as the overall spread level, but it focuses on the issuers perceived as facing extraordinary stress, even in relatively benign periods such as this. In fact, the distressed market 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 broadly similar to that shown by the overall speculative-grade spread, but with a nine-month lead time as opposed to one year. The current distress ratio, at 6.2% in July, corresponds to a roughly 2.25% default rate for April 2020.

Related Research

• Weakest Links Rise Among U.S. Health Care Service Providers, Aug. 20, 2019
• U.S. Refinancing--$5.2 Trillion Of Rated Corporate Debt Is Scheduled To Mature Through 2024, Aug. 15, 2019
• The Oil And Gas Sector Leads The Distress Ratio, Aug. 8, 2019
• For The U.S. Expansion, Are Trade Troubles "Just A Flesh Wound"?, June 25, 2019
• 2018 Annual U.S. Corporate Default And Rating Transition Study, May 7, 2019
• 2018 Annual Global Corporate Default And Rating Transition Study, April 9, 2019