Chart 1

S&P Global Ratings Research expects the European trailing-12-month speculative-grade corporate default rate to increase to 8% by December 2020, from 2.2% as of December 2019 (see chart 1).  The recession that has taken hold in Europe comes at a time when the speculative-grade market is vulnerable to a liquidity freeze combined with an earnings drop. The percentage of speculative-grade issuers with very low ratings ('B-' and lower) is at an all-time high of more than 20%. After China, Europe became the next epicenter of COVID-19, and first-half GDP is expected to decline significantly because of the containment efforts (see "COVID-19: The Steepening Cost To The Eurozone And U.K. Economies").

Expectations are for economic activity to decline quickly in the first half of the year, with revenues for companies in many sectors following suit.  We expect this to pressure funds from operations, working capital, and liquidity. While the substantial monetary and fiscal stimulus measures authorities are adopting to address short-term liquidity problems are important, they do not counter the weaker business environment many already vulnerable companies are exposed to. Furthermore, while emergency regulations in certain countries have suspended temporarily the requirement to file for insolvency and the associated wrongful trading liability for directors, they are unlikely to deter companies from undertaking distressed exchanges even in the near term. Once the health emergency has passed and the scale of the economic damage becomes clearer, we would expect to see a marked increase in debt restructurings.

Moreover, the sudden 50% collapse in the oil price only adds to the credit stress in the leveraged finance market.  The oil and gas sector was already one of the more vulnerable sectors from a default perspective. We now think the sector's contribution to the number of defaults will be even larger given the additional stress of falling oil prices in response to substantially increased supplies out of Saudi Arabia (see "S&P Global Ratings Cuts WTI And Brent Crude Oil Price Assumptions Amid Continued Near-Term Pressure"). And downgrades of European oil and gas companies have already started (see "Harsh Downturn Prompts Rating Actions On Multiple European Oil And Gas Companies").

In our pessimistic scenario, we forecast the default rate will rise to 11%.   The current assumptions for this year's recession are a two-quarter pullback in the first half of the year. To date, revisions to our economic forecasts have been frequent, and increasingly negative, and our economists believe risks are still to the downside. The pandemic might last longer and be more widespread than currently expected.

A more protracted recession or period of funding illiquidity would strain a larger percentage of currently higher-rated speculative-grade issuers.  Spreads may widen further, and there are indications this will happen. This would present a scenario similar in impact to the 2009 financial crisis in terms of economic decline and financial market volatility, heightening default rates across a wider range of the speculative-grade ratings spectrum.

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 pricing 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.

Market Pricing Reflects A Recession

History suggests that bond market spreads can be a good indicator of the general direction of defaults. The incredibly sharp and continuous rise in speculative-grade spreads indicates that credit markets are essentially pricing in a recession in the near to medium term (see chart 2). Our baseline default rate forecast of 8% is above what the historical trend would suggest, but we are now seeing spread trends that are similar to the lead-up to the financial crisis.

Chart 2

Alongside recent spread widening, speculative-grade corporate bond issuance has been nonexistent in March (see chart 3). The last speculative-grade bond issue came on Feb. 20, marking over a month without any activity. Meanwhile, in leveraged loans, only €150 million has come to market in March. Because of the depth of the recession expected, it may be some time before leveraged lending markets resume the pace set in January.

Chart 3

Despite such marked increases, 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 Europe was about 577 basis points (bps) below where our model would suggest. And though preliminary, the estimated spread on March 19 was 815 bps higher than the actual spread of 8.4% (see chart 4).

Chart 4

All Sectors Are Factoring In Stressed Expectations

Using the available U.S. sector-level spreads as approximate proxies for their European equivalents, it appears investors are pricing highly 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--falling demand plus increased supply. Although, the impact may be more muted in Europe because the observed widening in the U.S. incorporates a higher percentage of shale producers that have high operating expenses and little room for further efficiencies.

The sectors outside of oil and gas that have seen the largest relative increases in their spreads are health care, transportation, and aerospace and defense. Many of these sectors are leading the rout, given the fall in revenues expected in transportation, and specifically the airlines industry, as consumer mobility has ground to a halt to contain the virus' spread.

Chart 5

When looking at market pricing, which is reflective of expectations for issuers' performance, it is notable that many of the sectors at the higher end of spread widening (oil and gas, retailers, and consumer products) are a sizable amount of our total speculative-grade population, particularly for issuers rated 'B-' and lower (see chart 6). This implies a recession and future default rate that are both wide in scope.

Seven sectors have rating distributions that could be defined as weaker than the whole (based on the proportion rated 'B-' and lower). Leading this group is oil and gas--'B-' and lower rated issuers constitute a majority of the sector.

Chart 6

All of these stressors will be brought to bear at a time when the European speculative-grade population is at its weakest credit quality (see chart 7). At the start of the year, 22% of all speculative-grade issuers in Europe were rated 'B-' and lower, making for a relatively vulnerable starting point.

Ultra-low interest rates combined with growing demand for new loans by collateralized loan obligations have 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

Related Research

• COVID-19: The Steepening Cost To The Eurozone And U.K. Economies, March 26, 2020
• S&P Global Ratings Cuts WTI And Brent Crude Oil Price Assumptions Amid Continued Near-Term Pressure, March 19, 2020
• European Refinancing--€3.6 Trillion Of Rated Corporate Debt Is Scheduled To Mature Through 2024, March 5, 2020
• 2018 Europe Corporate Default And Rating Transitions Study, Dec. 12, 2019
• 2018 Annual Global Corporate Default And Rating Transition Study, April 9, 2019