Chart 1

S&P Global Ratings Research expects the European trailing-12-month speculative-grade corporate default rate to increase to 8.5% by June 2021 from 3.4% as of June 2020.   S&P Global economists have once again lowered their expectations for European economic performance in 2020 and 2021 because of the COVID-19 pandemic. We have also been witnessing an uptick in the default rate to a several years' high, alongside arguably the most pronounced deterioration in credit quality ever. That said, the pace of declines on the economic and credit fronts have been slowing recently, while the European Central Bank (ECB) recently expanded the Pandemic Emergency Purchase Program (PEPP) and the EU unveiled a new, massive fiscal debt stimulus, which includes pooled debt issuance across sovereigns and a large amount of forgivable loans.

In our pessimistic scenario, we forecast the default rate will rise to 11.5%.   In this scenario, we anticipate that the recession during the first half of the year will extend beyond the second quarter of 2020, or the subsequent recovery will be slower than S&P Global economists' current base case. A possible spike in COVID-19 cases later this year or early next, which would ultimately put extreme stress on many leveraged companies and households, could further complicate this scenario. This would result in a longer period of suppressed consumer spending, negligible business investment, and a longer period of higher unemployment, or underemployment.

In our optimistic scenario, we forecast the default rate will rise to 3.5%.   Once again, market signals are reflecting increasing optimism ahead and supporting a relatively suppressed default rate. Given current risk pricing in speculative-grade through both bond and leveraged loan spreads, ample liquidity and lending currently appear to support fewer defaults than in our base-case forecast. Given the success thus far in the ECB's PEPP in providing needed liquidity, its recent extension and expansion, as well as the EU's fiscal pact to share debt and provide hundreds of billions in grants, markets have reason to be optimistic and pursue corporate debt for its relative return compared to ultra-low yields on sovereign debt.

Base Case: Credit And Economic Deterioration Starts To Slow

The pace of credit deterioration in the first half of the year as a result of the COVID-19 pandemic and subsequent social-distancing measures was the most pronounced in the history of speculative-grade European corporates that we rate. Within the European speculative-grade population, sectors most vulnerable to social distancing--such as retail, consumer products, transportation, and leisure--constitute a particularly large portion of the total (39%). With another 6% of the total from the energy and natural resources sector, these stressed sectors account for 45% of the total.

These aggregate downgrades have resulted in a noticeable increase in the number of companies rated 'B-' and lower (see chart 2). The proportion of speculative-grade companies rated 'B-' and lower reached an all-time high of 32.5% at the end of June, topping the previous high from the start of the year by nearly 11 percentage points.

Chart 2

Within the speculative-grade segment, most of the largest sectors are likely to see further downgrades over the next 12 months, and, typically, downgrade momentum precedes defaults. Some sectors experienced net downgrade rates of 25% or more in the 12 months ended in June, with many also showing a net negative bias in excess of the overall speculative-grade total of 45% (see chart 3).

Both of these measures suggest particularly harsh credit conditions 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, energy and natural resources, aerospace, automotive, capital goods, and metal.

Chart 3

At a country level, credit stress and future expectations are much more uniform, relative to breakdowns by sector (see chart 4). Given the global impact of the coronavirus, this should not be surprising. That said, conditions in the U.K. are likely to have a larger relative impact on our European population given the large proportion of companies we rate from that country (26% of the total).

Despite widespread stress for many companies, particularly as it relates to revenue generation during lockdowns, the pace of downgrades has slowed markedly since April, and--while high--the current negative bias of our speculative-grade European corporate population is still short of its financial crisis peak.

Chart 4

The 12 months ended June 2020 has produced the highest level of credit deterioration since the peak of the 2008-2009 financial crisis and one of the fastest rates of deterioration between subsequent quarters (see chart 5). When looking at net rating actions, the negative 26% reading in the 12 months ended June 30, 2020, is the most extreme on record for Europe. The net negative bias is also high, with only three prior quarters registering larger net negative readings, and those were all during 2009 amid the financial crisis.

History shows that the rate of downgrades and net negative bias improve a few quarters prior to the peak default rate. That said, given the depth of deterioration in this last quarter, it appears there are still many more defaults to come.

Chart 5

Through the first half of 2020, nearly all of the defaults were due to missed interest payments, or distressed exchanges, which is in line with our prior expectations. Bankruptcies in Europe are generally rare by comparison to the U.S. However, much of this is due to stricter bankruptcy laws in Europe. Regardless, over 62% of defaults through June 30 have been a result of missed interest payments--well higher than any annual total in the last six years (see chart 6). Also, with half the year still ahead, 2020 has already seen the highest annual amount of defaults (16) since 2015. If we assume the second half of 2020 will produce an additional 16 defaults, this would push the 2020 speculative-grade default rate up to 4.5%.

Chart 6

Through the 12 months ended June 30, the speculative-grade default rate reached 3.35%. This was the result of 23 defaults over the period beginning July 1, 2019, and the highest default rate since the 12 months ended December 2013. This is above our long-term average default rate (since January 2002) of 3.1%, and proportionately well above the 2% average default rate over the protracted period of a relatively stable default rate from 2011.

Optimistic Scenario: Market Sentiment Reflects A Falling Default Rate

Fixed-income markets are reflecting a more modest default outcome over the next 12 months than the underlying credit fundamentals imply. This was somewhat striking given that debt issuance for high-yield bonds and leveraged loans dried up in March and April. However, markets came back to life in May and June (see chart 7). Having only seen a combined €2.7 billion in issuance between high-yield bonds and leveraged loans over the March-April period, primary markets saw €11.2 billion in May and just over €32 billion in June, pushing the year-to-date total to €105.5 billion. This puts the midyear 2020 total above the 2019 half-year total of €97 billion.

Chart 7

The total of new debt issued this year has marginally increased relative to 2019, and lending conditions on corporate loans remain largely neutral. In the most recent ECB bank lending survey from the second quarter, lending conditions tightening only minimally (net 1.4%). However, this could be considered somewhat disappointing given expectations for the second quarter were for substantial easing of lending standards based on the survey results in the first quarter (see chart 8).

Expectations for lending conditions on loans in the third quarter are extremely restrictive (23%). Perhaps providing some relief, the survey was conducted in mid-late June when most loan officers believed state loan guarantees in many of the region's larger economies would end. Since the massive fiscal stimulus enacted in July, these extreme expectations for tightening will likely prove overly cautious.

Chart 8

Meanwhile, market measures of lending conditions for lower-rated borrowers continue to reflect a more favorable environment (see chart 9). Spreads on both high-yield bonds and leveraged loans jumped quickly in March and April, only to retract nearly as quickly in May and June. The relative risk of holding corporate debt can be a major contributor to future defaults because companies face pressure if they are unable to refinance maturing debt. In broad terms, these speculative-grade spreads have been good indicators of future defaults based on a roughly one-year lead time. That said, at current spread levels, our baseline default rate forecast of 8.5% is well above what the historical trend would suggest.

Chart 9

Markets Remain More Optimistic Than Fundamentals

Similar to what we've been observing in the U.S. since the onset of the coronavirus pandemic, it is possible bond investors continue to be 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 June, the speculative-grade bond spread in Europe was about 445 basis points (bps) below where our model would suggest (see chart 10).

The average monthly gap between the actual and estimated spread has been 480 bps since February and could indicate that spreads are currently well below where the larger economy and financial markets would suggest. This divergence, taken into consideration with the European economic outlook and the fundamental credit backdrop for speculative-grade issuers, raises doubt that risk is adequately priced into markets, despite the estimated spread and the actual both trending downward since the end of April.

Chart 10

However, 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 central bank facilities and fiscal assistance programs but also to a falling number of active virus cases regionally. The potential benefits of reduced new virus cases and development of treatments or vaccines will not show up in traditional economic data such as the PMI, or will appear indirectly after more time passes.

Pessimistic Scenario: Downside Risks Are Still Considerable

In our pessimistic scenario, we anticipate the default rate could reach 11.5% (84 defaults) by June 2021. Here, we acknowledge the possibility of either a second wave of the virus and an increased caseload later in the year or in early 2021, or a slower recovery from the current global recession. Real-time measures of economic activity show that service sectors are still lagging behind manufacturing, and while the unemployment rate has remained low (compared with the U.S.), much of this muted rise in unemployment is also due to more workers leaving the labor force.

These factors would put greater stress on cash flow and require companies 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. In this scenario, we expect default rates for 'B-' and 'CCC'/'C' rated issuers to reach new highs.

Uncertainties Abound, And So Do Potential Outcomes

Given the unprecedented nature of the virus, resulting containment measures, fiscal and monetary responses thus far, and uncertainty around all of these factors, defaults could follow a path resembling an elevated plateau, as opposed to the historical peak-and-trough cycles of the past, regardless of which of these three scenarios is most accurate.

Regardless of the path of the economic recovery, corporations will carry much more debt in the years ahead. This will have to be financed through even more debt or will require organic revenue to grow at a faster pace than in the past. If a more drawn-out recovery does occur, refinancing obligations may become more difficult to repay, particularly for the weakest borrowers.

How We Determine Our European Default Rate Forecast

Our European default rate forecast is based on current observations and on expectations of the likely path of the European 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 3.5% in June 2021 (26 defaults in the trailing 12 months) in our optimistic scenario and 11.5% (84 defaults in the trailing 12 months) in our pessimistic scenario.

This study covers both financial and nonfinancial speculative-grade corporate issuers.

The scope and approach are consistent with our other ratings performance research publications globally--that is, our default and ratings transition studies. In this report, our default rate projection incorporates inputs from our economists that we also use to inform the analysis of our regional Credit Conditions Committees.

We determine our default rate forecast for speculative-grade European financial and nonfinancial companies based on a variety of quantitative and qualitative factors. The main components of the analysis are:

• Credit-related variables (for example, negative ratings bias and ratings distribution),
• The ECB bank lending survey,
• Market-related variables (such as corporate credit spreads and the slope of the yield curve),
• Economic variables (such as the unemployment rate), and
• Financial variables (for example, corporate profits).

For example, increases in the negative ratings bias and the unemployment rate are positively correlated with the speculative-grade default rate. As the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications increases, or the unemployment rate rises, the default rate usually increases.

By geography, this report covers issuers incorporated in any of the 31 countries of the European Economic Area (EEA), Switzerland, or certain other territories, such as the Channel Islands. The full list of included countries is: Austria, Belgium, the British Virgin Islands, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Gibraltar, Greece, Guernsey, Hungary, Iceland, Ireland, the Isle of Man, Italy, Jersey, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, Monaco, Montenegro, the Netherlands, Norway, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, Switzerland, and the U.K.

Related Research

• European Corporate Credit Outlook Mid-Year 2020: Living In A Different World, July 30, 2020
• European Economic Snapshots Suggest The Eurozone Will Recover Only Gradually, July 24, 2020
• Credit Conditions In Europe Find Some Respite As Curve Flattens And Recovery Unlocks, June 30, 2020
• Eurozone Economy: The Balancing Act To Recovery, June 25, 2020