Chart 1

S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to increase to 10% by December 2020 from 3.1% as of December 2019 (see chart 1).  The current recession in the U.S. this year is coming at a time when the speculative-grade market is historically vulnerable to a liquidity freeze or an earnings drop. The percentage of speculative-grade issuers with very low ratings ('B-' and lower) is now at an all-time high of just more than 30%.

Although short on hard data at this point, initial readings from China reflect a far harder economic impact from the virus and related containment efforts than expected, though stabilization has begun.  (For more, see "COVID-19 Macroeconomic Update: The Global Recession Is Here And Now," March 17, 2020.) With that as a proxy, expectations are for economic activity to decline quickly, with revenues for firms in many sectors following suit, and this is expected to pressure their working capital. The potential offset to the combined impact of low income and frozen funding markets is our expectations for substantial assistance in terms of monetary and fiscal stimulus aimed at providing liquidity and temporary assistance to firms and individuals.

We have previously anticipated the oil and gas sector to lead the default tally, but its impact will likely be even larger given the additional stress of falling oil prices in response to substantially increased supplies coming out of Saudi Arabia (see "Unrestrained Supply Swamps Oil Outlook: S&P Global Ratings Revises Oil & Gas Assumptions," March 9, 2020).

In our pessimistic scenario, we forecast the default rate will rise to 13%.   The current assumptions for this year's recession are a two-quarter pullback in the first half of the year. Despite the Fed having already launched multiple points of monetary stimulus, the general reaction by financial markets remains broadly negative thus far. This may change, though there is concern that the usefulness of monetary policies is far more limited relative to the financial crisis period of 12 years ago.

A more protracted recession or period of funding illiquidity combined with falling revenues would strain a larger percentage of currently higher-rated speculative-grade issuers.  Spread widening may also continue, and there is some indication that this is a growing possibility. This would present a scenario more similar to the financial crisis in terms of economic decline and financial market volatility, heightening default rates across a wider range of the speculative-grade ratings spectrum. In this scenario, the default rate would reach a new 40-year high.

This update to our default rate forecast comes at a time of limited hard data that might capture the economic impact of the coronavirus pandemic to date. Still, historical trends in default rates following significant changes in market swings, as well as experiences in times of recessions and illiquidity, offer useful guidance. The current ratings mix is an additional concern in the face of the current situation. We have previously raised the possibility of a double-digit default rate given some of these factors (see "A Double-Digit U.S. Default Rate Could Be On The Horizon," Oct. 2, 2019).

Markets Are Now Pricing In A Recession

History suggests that bond market spreads can be a good indicator of future defaults. If that historical relationship holds, credit markets are essentially at a point of pricing in a recession starting in the near to medium term (see chart 2). With this in mind, our baseline default rate forecast of 10% is above what the historical trend would suggest, though we are now seeing spread trends that are similar to the lead-up to the financial crisis.

Chart 2

Not coincidentally, as spreads have spiked, speculative-grade corporate bond issuance has essentially disappeared in recent weeks (see chart 3). In fact, since Feb. 21, there has been only one speculative-grade company to issue bonds (CCO Holdings LLC). Meanwhile, leveraged loans have seen just $1.3 billion in issuance in March, with only $380 million of that in institutional loans.

Chart 3

And despite such quick and grim market reactions, investors may still be slightly more optimistic than the underlying economy and financial markets suggest. Using a model based on broad measures of financial market sentiment, economic activity, and liquidity, we estimate that, at the end of February, the speculative-grade bond spread in the U.S. was about 411 basis points (bps) below where our model would suggest. And though preliminary, the estimated spread on March 16 was 793 bps higher than the actual spread of 764 bps (see chart 4).

Chart 4

Extreme Market Reactions Are Leaving No Sector Spared

Investors are pricing negative expectations into nearly every sector (see chart 5). Unsurprisingly, oil and gas has experienced the largest spread widening given it's facing two major stressors, but only the telecommunications sector has yet to see its spreads double in the year to date.

The sectors outside of oil and gas that have had the largest relative increases in their spreads are health care, transportation, and aerospace and defense. These sectors are leading the rout because of the strain from the fall in revenues expected in transportation, and more specifically airlines, as consumer mobility grinds to a halt to contain the virus' spread.

Chart 5

When looking at market pricing--and considering that it reflects future expectations for issuers' prospects--it is notable that many of the sectors that are experiencing the biggest increases in spreads (oil and gas, health care, retailers, and consumer products) account for a large portion of our speculative-grade population, particularly 'B-' and lower (see chart 6). This implies a recession and future default rate that are both wide.

Chart 6

The combination of a global recession, financial market volatility, and a collapse in oil prices will be brought to bear at a time when the U.S. speculative-grade population is at its weakest credit quality (see chart 7). At the start of the year, 30% of all speculative-grade issuers in the U.S. were rated 'B-' and lower, making for a very vulnerable starting point.

Low interest rates combined with surging demand for new loans by collateralized loan obligations has brought many new issuers to market in the last three to four years. Many of these companies will be tested, particularly in sectors reliant on consumer mobility such as airlines, cruise ships and other leisure, transportation, and oil and gas.

Chart 7

In the post-crisis period, distressed exchanges have become popular among companies in hardship, and we classify these as selective defaults, consistent with our criteria. On an annual basis, they have accounted for a somewhat steady 40%-45% of the total in the period since the financial crisis (see chart 8). We expect many defaults in the remainder of the year to fall into this category--either at historical levels or even higher.

Chart 8

Related Research

• A U.S. Recession Takes Hold As Fallout From The Coronavirus Spreads, March 17, 2020
• COVID-19 Macroeconomic Update: The Global Recession Is Here And Now, March 17, 2020
• COVID-19 Credit Update: The Sudden Economic Stop Will Bring Intense Credit Pressure, March 17, 2020
• Unrestrained Supply Swamps Oil Outlook: S&P Global Ratings Revises Oil & Gas Assumptions, March 9, 2020
• Global Refinancing--Rated Corporate Debt Due Through 2024 Nears $11 Trillion, Feb. 3, 2020
• A Double-Digit U.S. Default Rate Could Be On The Horizon, Oct. 2, 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