Chart 1

S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to increase to 12.5% by March 2021 from 3.5% as of March 2020 (see chart 1).  Since our March update to the U.S. default forecast, S&P Global economists have lowered their expectations for U.S. economic performance amid the COVID-19 pandemic. We also saw both an uptick in defaults as well as a historically high number of downgrades and negative outlook and CreditWatch placements in April, as a result of the virus, social distancing measures to fight it, and the acute stress in the oil and gas sector from collapsing oil prices. We expect this general deteriorating credit trend to continue as many firms, particularly speculative-grade (rated 'BB+' or lower) companies in some of the weakest and most affected sectors, find their solvency stretched amid falling revenue.

In our pessimistic scenario, we forecast the default rate will rise to 15.5%.  In this scenario, we anticipate the economic drag will extend beyond the second quarter of 2020 and the subsequent recovery will be slower than S&P Global economists' base case. A possible resumption of COVID-19 cases later this year or early next, which would ultimately put extreme stress on many leveraged firms and households, could further complicate this scenario. This would result in a longer period of suppressed consumer spending, already at an all-time low, and a longer period of high unemployment.

In our optimistic scenario, we forecast the default rate will rise to 6%.  Here we turn our expectations to be roughly in line with what market signals are implying about future default activity. Compared with our base-case assumptions, fixed-income markets appear optimistic, given current risk pricing even among the weakest issuers. This is likely the manifestation of a combination of factors, such as the Federal Reserve's new liquidity facilities, a recent slowing pace of new infections nationally, and encouraging news regarding vaccine and treatment research.

Base Case: Credit Deterioration Continues

In the first quarter of the year, downgrades among speculative-grade companies rose markedly, particularly in March. This continued in April as well, amid the stress of falling revenue due to the demand shock from social distancing measures and collapsing oil prices, which reached negative territory on April 20.

These downgrades have resulted in a noticeable increase in companies rated 'B-' and 'CCC' to 'C' (see chart 2). The proportion of speculative-grade companies rated 'B-' and lower reached an all-time high of 35% at the start of the second quarter, topping the previous high from the start of the year by a full 5 percentage points.

Chart 2

The proportion of new issuer credit ratings at 'B-' and lower has also reached a multidecade high of 49% in the U.S. (see chart 3). The upswing in this ratio since 2017 has coincided with recent years' surge in collateralized loan obligation (CLO) issuance, providing ready demand for new debt. Periods of quick growth in the proportion of the lowest ratings among newly rated issuers have preceded prior spikes in the default rate to double-digit levels. This reflects the likelihood that any surge in lower-rated issuers would in part reflect a certain level of overexuberance in fixed-income markets, which could enable weaker, newer borrowers to obtain financing they might otherwise not.

Chart 3

Within the speculative-grade segment, most sectors are likely to see increased downgrades over the next 12 months, and typically downgrade momentum precedes defaults. Some sectors in the first quarter experienced a net rating action rate (the upgrade rate minus the downgrade rate) of -30% or more, with most of these also showing a net bias (positive bias, or the proportion of issuers with positive outlooks or ratings on CreditWatch positive, minus negative bias) in excess of -40% (see chart 4). Both of these measures imply particularly harsh conditions for creditworthiness and expectations for this to continue. This is most obvious in sectors under the greatest stress as a result of the virus and collapsing oil prices: leisure time/media, consumer services, transportation, and energy and natural resources.

In April, the net bias fell further to -47% as the negative bias for all speculative-grade companies reached 50%. As of May 15, the net bias reached -49%, with the negative bias at 52%. This marks an all-time high for the negative bias, breaking the prior high of 47% from March 2009.

Chart 4

The first quarter of 2020 has produced the highest level of speculative-grade credit deterioration since the 2008-2009 financial crisis (see chart 5). Currently, the net downgrade rate and the net bias are reflecting heightened downgrades and increased prospects for future downgrades as the impact of the coronavirus and resultant social distancing measures sap earnings and strain cash flow.

To put this pressure in historical context, only the first and second quarters of 2009 showed greater rates of net downgrades with higher net negative bias. As expected, default rates reached double digits a few quarters later, in November 2009.

Chart 5

Economic Signals Portend More Defaults

Economic and financial conditions have turned at a time when the weakest-rated borrowers represent their highest proportion of the speculative-grade market ever. Industrial production contracted the most since 2009 in the first quarter (see table). Corporate aftertax profits were positive at end-2019 but fell sharply lower in the first quarter of 2020, with initial earnings for the S&P 500 showing a drop of 14% with more than 85% of companies reported (as of May 15). Market volatility, as measured by the VIX, is currently about 30 after spiking to an all-time high of 82.7 in March and ending the first quarter around 54.

Meanwhile, the Fed reports lending conditions tightened the most since 2009 in the first quarter after appearing broadly neutral in the fourth quarter. In the most recent survey, respondents reported significant tightening of standards and terms on commercial and industrial loans to firms of all sizes. Standards were also tighter across the three major commercial real estate loan categories (construction and land development loans, nonfarm nonresidential loans, and multifamily loans) and all three consumer loan categories (credit card loans, auto loans, and other consumer loans), while some survey respondents reported tightening standards on residential real estate loans as well.

Stress Spreads Beyond Energy And Retail

So far in 2020, we've seen elevated downgrades, with 324 as of March 31, compared with 365 in all of 2019. Among those were 96 companies downgraded to 'B-' or lower from 'B' or higher. For comparison, 134 companies were downgraded to 'B-' or lower from 'B' or higher in all of 2019. Of these 96 companies, 76 are assigned negative outlooks or are on CreditWatch with negative implications. The pace of issuer downgrades to 'B-' or lower from 'B' or higher continued into the second quarter. In less than five months, the count of such downgrades is challenging the last annual peak, seen during 2008 amid the global financial crisis.

Given the broad-based credit deterioration that's continued into the second quarter, we expect defaults to be elevated in several sectors compared with recent years, when defaults were relatively muted outside of energy and natural resources and consumer services. Through April, half of this year's defaults have come from sectors beyond energy and natural resources and consumer services (see chart 6). Since 2015, these two sectors have accounted for the vast majority of the annual default totals in the U.S.

Chart 6

The outlook for the retail sector shifted dramatically in March as businesses were forced to shutter and supply chains were severed. In April, retail sales experienced their highest year-over-year decline in history, with a reduction of almost 22%. The secular trend toward e-commerce, whose rapid rise has left traditional retailers contending with low foot traffic for years, may permanently capture consumer preference whenever a post-COVID world does arrive. The business environment for consumer services companies won't be any more accommodating in the meantime.

The COVID-19 impact has been the sharpest for leisure time/media issuers, which include hotel, casino, and entertainment businesses. Facing an abrupt drop in demand due to social distancing policies, hotel and lodging companies will be significantly affected, with revenue per available room in decline as long as travel is canceled or postponed. Entertainment companies, such as live-event businesses and movie exhibitors, are facing the same difficult reality that a post-COVID world likely won't be as hospitable as the one they grew up in, with business conditions until then even grimmer.

Meanwhile, the secular changes that had weakened oilfield service and exploration and production companies for years likely set up many issuers for default after the extraordinary combination of the pandemic and Russia-Saudi oil price war, which left liquidity even scarcer. As a result, access to capital has diminished further, especially for lower-rated speculative-grade issuers, among which distressed exchanges had been common.

One sector where risk may be building more than currently appreciated is health care/chemicals. Leading up to the pandemic, secular trends such as pressure to lower health care costs and rural-urban migration were pressuring health care businesses. The pandemic has hit issuers in this sector just as hard as other service-based companies, with many forced to close or curtail operations. If some of these issuers were to default, it could exacerbate problems with regional health care system capacity.

Optimistic Scenario: Markets Suggest Only A Modest Rise In Defaults

Fixed-income markets have responded with enthusiasm to the Federal Reserve's creation of various lending facilities on March 23 and its expansion of these facilities' purview in April. Investment-grade (rated 'BBB-' or higher) bond issuance hit historically high monthly totals in March and April, at $247 billion and $223 billion, respectively. The previous monthly record was $153 billion, in May 2016.

Within the speculative-grade segment, bond issuance also bounced back in April after a drought in March, though leveraged loans are still faring slightly worse. Total issuance for speculative-grade bonds and leveraged loans together returned to its pace from April of last year after nearly no issuance in March (see chart 7).

Chart 7

The Fed's $750 billion Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility entail direct buying of investment-grade corporate bonds in the primary and secondary markets. On April 9, the facilities were expanded to include the debt of recent fallen angels--issuers downgraded to speculative grade. This marks the first time the Fed has ventured into purchasing corporate bonds directly, as the European Central Bank (ECB) has done in years past, and leapfrogs the previous ECB measures by purchasing speculative-grade bonds, even if only those of firms with investment-grade ratings prior to the COVID-19-related downturn.

As of this writing, neither of these facilities has yet been tapped by any issuers, with all of the observed positive market impact being indirect, likely rooted in the belief that the Fed will expand these facilities as needed if the economic and financial situation should worsen in the near future.

Alongside renewed bond issuance, corporate spreads have fallen in secondary markets recently. 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 8). That said, at current spread levels, our baseline default rate forecast of 12.5% is well above what the historical trend would suggest.

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 believe the corporate distress ratio is a more targeted indicator of future defaults across all points in the credit and economic cycles (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 basis points 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. 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.

That said, even with a distress ratio of 30% in April, the corresponding default rate for January 2021 is roughly 6.3%, well below our current base-case default rate forecast. However, amid elevated distress, variability in the default rate tends to increase, which may leave potential for a higher default rate than 6.3%.

Caveats abound

It is possible bond investors are more optimistic than the underlying economy and financial markets suggest. Using a model based on three broad measures--the VIX, the M1 money supply, and the Purchasing Managers' Index (PMI)--we estimate that at the end of April, the speculative-grade bond spread in the U.S. was about 400 basis points (bps) below where our model would suggest (see chart 10).

This is the largest gap between the actual and estimated spread since our series began in 2003, and could indicate that spreads are currently far below where the larger economy and financial markets would suggest. Through most of the period since the 2008-2009 recession, the spread was slightly higher than predicted. But the predicted level has exceeded the actual for 25 of the past 28 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.

This divergence, taken into consideration with the U.S. economic outlook and credit fundamentals for speculative-grade-rated issuers, raises doubt that risk is adequately priced into markets. It appears more likely than not that there's more pain to be felt.

Chart 10

Certainly, just as the nature of the current stress caused by the coronavirus is particularly unusual and difficult to predict, so too are the potential upsides to the current situation. Markets have not only been reacting positively to the Fed facilities and fiscal assistance programs, but also to a falling number of active virus cases nationally. But it should be noted that all or at least most of the reduction in cases seen recently is the direct result of fewer cases in New York, while new cases continue to arrive at an increasing pace elsewhere in the country. Still, the potential benefits of reduced new virus cases and the development of treatments or vaccines will not show up in traditional economic data such as the PMI, but only indirectly through financial market optimism.

Although a vaccine is still estimated to be some time away, research at this point appears promising, as does emergency use of treatment methods such as Gilead Sciences Inc.'s remdesivir, which, if successful, should reduce the death rate associated with the virus. Still, these positive developments are some ways away from becoming widespread solutions.

On the monetary policy side, we estimate the $600 billion Main Street Lending Program, aimed at providing loans to small and medium-size firms, will have only a small impact on the speculative-grade market in its current form. We estimate that only 44% of the firms we rate speculative grade in the U.S. would qualify, given the various eligibility criteria related to annual revenue, maximum number of employees, and limits on issuer leverage. Of these, eligibility is highly correlated with credit quality: A higher proportion of 'BB' issuers (62%) than 'CCC'/'C' issuers (31%) would qualify. Further, for those that do qualify, there is a $25 million limit on new loans extended by the facility and a $200 million cap in the expanded loan facility for existing loans. This limits the amount of funds available to relieve stress on an already limited portion of speculative-grade companies we rate.

Pessimistic Scenario: Prolonged Closures Starve More Companies Of Cash For Longer

In our pessimistic scenario, we anticipate the default rate could reach levels not seen before. For now, we believe it could reach 15.5% (289 defaults) by March 2021. Here we factor in a number of negative outcomes as a result of a resumption of the virus and an increased caseload later in the year or in early 2021. Consumer spending would contract even more steeply than in S&P Global economists' baseline forecast (42% versus 34%) as social distancing measures resume or amplify. Unemployment would also rise, and GDP would end up lower than the baseline assumption and take longer to rebound.

All of this would put greater stress on cash flow and require firms to look to issue new debt at a time of increased hardship and uncertainty, which would either lead to higher borrowing costs or another closing of the primary markets. The Fed would almost certainly be expected to provide more market liquidity, but considering the positive impact thus far has been indirect for the speculative-grade segment--and has come alongside a leveling off of new cases and incremental, albeit positive, developments in vaccine and treatment research--any future benefit from the monetary side may be muted for weaker issuers. In this scenario, we expect historical default rates for 'B-' and 'CCC'/'C' rated issuers to expand to new highs.

Unprecedented Times

Because of the wide range of possibilities, it is perhaps more appropriate to think of our default scenarios as separate possible outcomes rather than simply a range. Given the unprecedented nature of the virus, resulting containment measures, fiscal and monetary responses thus far, and the uncertain path ahead for all of these factors, it is also possible that regardless of which of these three outcomes is more accurate, defaults could follow a path resembling an elevated plateau, as opposed to the historical peak-and-trough cycles of the past.

Most support to date has been in the form of increased market liquidity via borrowing, rather than direct subsidies. This means that most funds received to date come with the obligation to be repaid. If another round of similar stimulus provides for more debt issuance, it will likely come during a period of reduced revenue, making for even higher debt burdens moving forward, which either will have to be financed through even more debt or will require organic revenue to grow at a faster pace than in the past. Even in S&P Global economists' base case, this faster pace of organic revenue generation is unlikely, given the expectation for a drawn-out economic recovery.

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 6% in March 2021 (112 defaults in the trailing 12 months) in our optimistic scenario and 15.5% (289 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 issuer base.  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.

Related Research

• Transportation Leads Distress Ratios As Demand Collapses Across U.S. Sectors, May 26, 2020
• More Than One-Quarter Of Speculative-Grade Issuers Are Weakest Links, May 14, 2020
• 2019 Annual Global Corporate Default And Rating Transition Study, April 29, 2020
• FAQ: How The Fed Changed The U.S. Corporate Funding Landscape, April 23, 2020
• Economic Research: An Already Historic U.S. Downturn Now Looks Even Worse, April 16, 2020
• Global Refinancing--Rated Corporate Debt Due Through 2024 Nears $11 Trillion, Feb. 3, 2020