Chart 1

S&P Global Ratings Research expects the European trailing-12-month speculative-grade corporate default rate to fall to 5.25% by March 2022 from 6.1% as of March 2021 (see chart 1).   S&P Global economists expect the eurozone economy to rebound in 2021 to 4.2% GDP growth after contracting 6.8% in 2020. Despite some setbacks, vaccine deployment is back on track in Europe, and we anticipate that significant fiscal support measures will remain in place in 2021. The EU Next Generation plan is expected to inject roughly €750 billion into national economies, and we expect the GDP of the largest contributor to our speculative-grade population--the United Kingdom--to grow roughly 11% through 2022. Still, obstacles remain for sectors dependent on in-person interaction (hotels, gaming, media and entertainment, leisure), as well as the oil and gas sector. These may take several years to recover and will likely produce most of the defaults in the months ahead.

In our optimistic scenario, we forecast the default rate will fall to 2.5%.  Market signals continue to indicate optimism and a declining default rate through next March. Current speculative-grade risk pricing--through both bond and leveraged loan spreads and a lower proportion of distressed leveraged loans--reflects ample liquidity, which has helped produce the strongest quarter of combined high-yield bond and leveraged loan volume. Expansive monetary support during the pandemic has helped push borrowing costs to new lows, while expectations for stronger economic growth later this year are fueling a general sense of optimism.

In our pessimistic scenario, we forecast the default rate could rise to 7.5%.   Our ratings mix is particularly weak among European speculative-grade firms. Just under one-third of our speculative-grade ratings are 'B-' or lower, leaving the region vulnerable to a disruptive shock, and there are still several that could be potential stumbling blocks: potential mutations of the virus, any setbacks in the immunization effort, and unexpected policy missteps. Over 20% of all speculative-grade ratings 'B-' and lower are in the hard-hit media and entertainment sector, which we expect will take several years to return to its 2019 credit metrics.

We may also see a historically elevated default rate over the longer term.   With improving economic trends, optimistic forecasts, easing terms of debt financing, and improving credit trends, we anticipate further outlook stabilizations rather than a wave of upgrades ahead. This will leave the already weak rating distribution in place, which may slow the decline in default rates in the years ahead (see chart 2). Extensive fiscal and monetary supports have helped suppress small enterprise bankruptcy filings throughout the region since 2020, but small business bankruptcies are expected to bounce back once supports are withdrawn. This may have spillover effects for our rated issuers (which tend to be larger firms that have mostly benefited from enhanced market liquidity as opposed to fiscal supports) through possible supply chain disruptions, higher unemployment, or decreased consumer spending.

Chart 2

Credit Metrics Show Improving Trends

The European speculative-grade population suffered a large wave of downgrades and increased negative bias a little over a year ago. But as vaccine prospects increased later in the year and economic restrictions had less impact than those during second-quarter 2020, the pace of downgrades subsided, as did the negative bias (see chart 3). Downgrades and defaults picked up again in September and October, however since July 2020, the average monthly pace of speculative-grade downgrades has been 11--the same monthly pace as in 2019. As economic prospects and market liquidity have continued to improve, 2021 has actually seen more upgrades than downgrades. This is not to suggest, however, that we expect a large swath of upgrades in the months ahead. Still, the accelerated pace of negative credit momentum appears to have subsided.

Chart 3

This slowing of downgrades has varied widely across sectors (see chart 4).   The overall speculative-grade net rating actions (the upgrade ratio minus the downgrade ratio) of -17% in the 12 months ended in March were far below the leisure (-42%) and aerospace/automotive/capital goods/metals (-37%) sectors. Meanwhile, nearly all other sectors had a net rating action rate very close to--or even higher than--the overall population. And outside of the leisure and transportation sectors, most had a net negative bias roughly in line with the overall speculative-grade total of 27%.

Chart 4

Rating actions over the course of 2020 led to a much weaker overall ratings mix among speculative-grade entities, but this varies widely across industries (see chart 5). This leads us to believe that some sectors will contribute more defaults than others, including media and entertainment (which includes lodging, gaming, and other point of contact-based entertainment), oil and gas, retail/restaurants, and transportation. These sectors have particularly weak rating distributions--for the most part, they have more issuers rated 'CCC'/'C' than the overall speculative-grade population. Thus far, we largely expected this divergence, which is consistent with our belief in a "K-shaped" economic recovery over the next few years. These sectors will likely see slower recoveries in their financial status and should lead the default tally ahead.

Chart 5

In the 12 months ended March 2021, we saw a sharp easing of credit deterioration (see chart 6). When looking at net rating actions, the -17% reading in the 12 months ended March 2021 was a significant reduction from the -25% reading in the 12 months ended December 2020. This marked improvement was not unexpected, as the large swath of downgrades seen in March 2020 have been removed from the trailing-12-month window. We expect a similar trajectory for the 12 months ending June 2021 for similar reasons. Nonetheless, first-quarter 2021 did see net upgrades for European speculative-grade corporates.

Chart 6

History shows that the rate of downgrades and net negative bias tend to lead the movement in the default rate by several quarters. If this pattern holds, the marked improvement in the direction of credit quality through first-quarter 2021 would suggest the peak default rate may have already passed or is close at hand.

Most European defaults in 2020 (91%) were a result of distressed exchanges or missed interest payments, and this trend has continued into 2021 (see chart 7).   In our default statistics and forecast, we include both 'SD' (selective default) and 'D' ratings as instances of default (S&P Global Ratings views distressed exchanges as selective defaults). Selective defaults also tend to result in much lower levels of economic loss (higher recoveries). In the first four months of 2021, 70% of defaults in the region were distressed exchanges, with one more on May 10 (Gategroup Holding AG).

Chart 7

The pace of defaults thus far in 2021 has been more modest compared to 2020. Through April, there have been 10 defaults in Europe, which if annualized, would result in an approximately 4% default rate for 2021. That said, it is important to consider that 74% of all distressed exchanges are ultimately followed by additional default events. Thus far in 2021, one default was a recent repeat defaulter from 2020: Spanish gaming company Codere SA, which missed an interest payment on April 30, 2021, after first executing a distressed exchange on Oct. 15, 2020.

Through the 12 months ended March 31, the speculative-grade default rate reached 6.1%--the highest default rate since the 12 months ended April 2010. This is above our long-term average default rate (since January 2002) of 3.1%, and proportionately well above the 2.2% average default rate over the protracted period of a relatively stable default rate starting in 2011. The most recent data suggests that the default rate fell to 5.9% in the 12 months ended April, perhaps implying the March reading to be the peak.

Markets Anticipate Fewer Defaults Ahead, And Bolster Lending

Despite lingering risks, fixed-income markets are reflecting more modest default expectations than credit fundamentals imply. Debt issuance rebounded in the second half of 2020, and that momentum has accelerated in the first quarter of this year (see chart 8). Similar to the U.S., the first quarter combined high-yield bond and leveraged loan issuance total has reached the highest level in years and is several months ahead when compared to the pace in 2020. Combined high-yield bond and leveraged loan issuance totaled €96 billion in the first quarter--approximately the same total as in the first half of 2019 and 2020. March alone added more than half of the first quarter volume with €42.4 billion. Much of the first-quarter total was used for refinancing existing debt, as issuers experienced some of the most favorable borrowing costs in years.

Chart 8

Combined debt issuance among speculative-grade issuers saw a boom in the first quarter as financing conditions eased (see chart 9). In the most recent European Central Bank (ECB) bank lending survey from the first quarter, lending conditions still tightened on net (7% on all enterprises by size), however this was a noticeable decline from the 25% net tightening reading in the fourth quarter, and well below expectations for the first quarter among participating banks at the time. Looking at projections for the second quarter, banks expect lending conditions to tighten a net 5%.

Chart 9

Market pricing for lower-rated borrowers continues to reflect favorable lending conditions (see chart 10). Spreads on both speculative-grade bonds and leveraged loans have continued to fall in 2021, with the speculative-grade bond spread now below where it began 2020.

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 spreads, our baseline default rate forecast of 5.25% is well above what this historical trend would suggest.

Chart 10

Market Optimism Appears Warranted

Similar to what we've observed in the U.S. since the onset of the coronavirus pandemic, it's possible bond investors have been more optimistic than the underlying economy and financial markets implied. However, in March, it appears that the actual spread and estimated are more closely matched, implying appropriate risk perceptions on the part of investors. This is likely due to the extraordinary levels of monetary support by the ECB, which in 2020 created the pandemic emergency purchase program to--in part--provide a liquidity backstop for sovereign and corporate bond markets. Using a framework based on broad measures of financial market sentiment, economic activity, and liquidity, we estimate that at the end of March, the speculative-grade bond spread in Europe was about 108 basis points (bps) above our estimation (see chart 11).

Chart 11

The average monthly gap between the actual and estimated spread was 298 bps in 2020. However, this gap has narrowed considerably in recent months, and turned negative in March, largely because of a reduction in equity market volatility and improving industrial confidence. In April, industrial confidence reached an all-time high of 10.7, which should push the estimated spread tighter still.

Vulnerability Is Elevated And Solvency Concerns Remain

In our pessimistic scenario, we anticipate the default rate could reach 7.5% (55 defaults) by March 2022.   Here, we acknowledge that despite an easing in downgrades and negative bias in recent months, our rating distribution remains very weak as a result of the large number of downgrades during 2020. Roughly one-third of all our European speculative-grade ratings are at 'B-' or lower, making them vulnerable to any disruption in the economy or financial markets. Those that are most likely as of this writing include potential mutations of the virus, any setbacks in the immunization effort, and unexpected policy missteps. Unsurprisingly, many of these weaker ratings are in sectors that have been hardest hit by the pandemic, with over 20% in the media and entertainment sector alone. These weaker sectors are expected to take years to restore their 2019 credit metrics, which leaves concern over longer-term solvency on our watchlist for some time ahead.

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.  

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

The scope and approach are consistent with our default and rating transitions 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 (corporate credit spreads and the slope of the yield curve), economic variables (the unemployment rate), and financial variables (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 the 31 countries of the European Economic Area, 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.

S&P Global Ratings believes there remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Related Research

• European Leveraged Finance And Recovery First-Quarter 2021 Update: Financial Flexibility Trumps Deleveraging, May 13, 2021
• Economic Research: Why The U.K.’s Worse Recession Should Turn Into A Stronger Recovery, May 12, 2021
• European Corporate Support Schemes: Extending And Amending, April 30, 2021
• European Economic Snapshots: Unlike The Rest Of Europe, The U.K. Is Looking Beyond COVID-19, April 28, 2021
• Next Generation EU Will Shift European Growth Into A Higher Gear, April 27, 2021
• European Corporate Credit Outlook: Struggling To Get Back On Track, Feb. 3, 2021