Chart 1

Baseline: S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to decline to 2.5% by June 2022 from 3.8% as of June 2021 (see chart 1).   Economic growth is expected to remain robust through 2023, with our economists revising their GDP estimates through 2023 up from their prior estimates in the second quarter. On the credit side, the pace of speculative-grade upgrades has outpaced downgrades by about 3-to-1 in 2021, and in aggregate, our outlooks and CreditWatches point to fewer downgrades ahead.

Optimistic scenario: We forecast the default rate will fall to 2%.   This scenario builds on a relatively benign baseline projection and reflects what market signals are implying about future default activity. Demand for speculative-grade debt has been historically high this year as yields continue to fall and issuance through July has already eclipsed full-year averages, supporting liquidity for even the lowest rated firms. By many measures, investor optimism appears largely warranted as the economy rebounded alongside falling volatility in broader financial markets. Additionally, the amount of outstanding debt to be refinanced in the next 12 months is much lower than usual because of the wave of opportunistic refinancing over the previous 12 months.

Pessimistic scenario: We forecast the default rate will rise to 5.5%.   Our ratings distribution remains weak among speculative-grade firms (see chart 2). Some 38% of our speculative-grade ratings ('BB+' or lower) are 'B-' or lower, leaving them vulnerable to a disruptive shock such as potential COVID-19 mutations, prolonged inflation, or if pent-up consumer savings fail to spur spending and revenue. Many issuers rated 'B-' or lower are in sectors hardest hit by the pandemic and will likely take several years to return to 2019 credit metrics. We would expect the Federal Reserve to intervene if markets became illiquid again, but any situation involving more economic lockdowns (voluntary or involuntary) could further strain many firms trying to recover from 2020.

Chart 2

Credit Quality Starts To Rebound

With a strong U.S. economic recovery underway, the speculative-grade negative bias fell nine percentage points to 21% in the second quarter, as outlooks on many issuers were revised to stable from negative without being downgraded, a trend continued from the first quarter. The speculative-grade positive bias also improved during the quarter, rising two percentage points to 11%.

The speculative-grade net bias (the positive bias minus the negative bias) increased 11 percentage points to -10% in the second quarter. Rating actions continue to reflect the improving outlook for credit; second-quarter 2021 was the fourth consecutive quarter with fewer speculative-grade downgrades and more speculative-grade upgrades than in the previous quarter. At the end of the second quarter, just two sectors had both a net negative bias and net negative rating actions, down from seven in the first quarter (see chart 3).

Chart 3

Based on trends in rating actions and rating bias, the sudden and acute recession in 2020 led to the sharpest credit deterioration ever in speculative-grade ratings (see chart 4). The pace of recovery has been nearly just as sharp, with the speculative-grade net rating bias and net rating actions fully recovering in just four quarters. The level of speculative-grade net rating actions is currently at a level it hasn't been since the first-quarter 2012, while the net rating bias is at a level last seen near third-quarter 2018.

Chart 4

Default Signposts Continue To Reflect Improvement

Measures of economic and financial conditions in the second quarter reflect the strong economic recovery and ample liquidity (see table 1). The Fed survey on lending conditions fell to -15.1 in April, continuing the sharpest drop since the survey began in 1990. In July the survey for large and middle-market firms fell again to -32.4, reflecting the easiest lending standards for these firms in the survey's history.

There were brief periods of market volatility, with the VIX spiking higher during the second quarter in May and June, but volatility remains in a downtrend. Importantly, credit markets continued to shrug off episodes of volatility, with the speculative-grade credit spread grinding tighter in the second quarter, reaching 357 basis points (bps), the tightest since May 2019. However, in the third quarter spreads widened by as many as 41 bps, as investors reprice growth and inflation assumptions, and as the Delta variant pushes COVID-19 back to the forefront. Improvement in economic and financial data should moderate from here after the sharp recovery from the 2020 recession, and downside risk to our base-case assumptions are fairly optimistic.

Table 1

Trend Of Fewer Defaults Continues

We expect the recovery in speculative-grade issuer credit quality to lag the overall economic recovery. Following the initial spike in default activity in 2020, issuers have avoided default in many cases with ample liquidity support from capital markets and as business conditions improved. Defaults continued to trend lower in the second quarter with 11, the fewest since third-quarter 2018 (see charts 6 and 7).

Chart 5

While credit quality is improving on the back of more speculative-grade upgrades than downgrades in 2021, this is nowhere near the number of downgrades in 2020. This has left the proportion of issuers with the lowest ratings still historically high. The proportion of speculative-grade issuers rated 'B-' or lower fell slightly in the second quarter to 38%, compared with the all-time high of 40% at the same time last year. The proportion of speculative-grade issuers rated 'CCC'/'C' fell further to 11%, down from the all-time high of 17% in May 2020.

There are 215 'CCC'/'C' U.S. corporate rated issuers, led by consumer/service (61), leisure time/media (41), and aerospace/automotive/capital goods/metal (35). On average, from 1981 to 2020, about 30% of U.S. corporate issuers that began the year rated 'CCC'/'C' defaulted within one year.

Chart 6

In the second quarter, energy and natural resources (four), consumer/service (two), and health care/chemicals (two) led all sectors with the most defaults. The energy and natural resources and consumer/service sectors accounted for more than three-fifths of defaults in 2020, as these issuers were disproportionately affected by the sudden recession and the collapse in oil prices.

Even as the energy and natural resources and consumer/service sectors continued to lead defaults in the second quarter, there is a downtrend in defaults from these sectors in line with the broader trend of lower defaults since the second quarter of 2020. While we expect the credit impact of the pandemic to linger for certain industries, the outlooks for these sectors have substantially improved with the U.S. economy.

The outlook for the consumer/service sector improved as the vaccine rollout led to eased restrictions on businesses and strong consumer spending in 2021. However, we don't expect credit metrics for issuers in discretionary retail and discretionary consumer products to broadly recover until 2022.

The outlook for the energy and natural resources sector has improved as OPEC+ supply cuts continue to support oil prices, even with the strong recovery in demand. We still do not expect the price of WTI to remain far above the average break-even price for U.S. shale (near $50), and with shale producers' capital expenditures likely limited in the near term, oilfield services and exploration and production companies remain vulnerable. We don't expect credit metrics in the oil and gas sector to broadly recover until 2022.

In line with the broader trend, defaults in the leisure time/media sector have trended lower since second-quarter 2020. While credit deterioration was substantial in the leisure/time media sector, issuers have largely avoided default.

The outlook in the leisure time/media sector improved as advertising trends strengthened and in anticipation of an uptick in spending on travel, entertainment, and lodging in the second half of the year. Still, secular pressures that worsened during the pandemic continue to be a downside risk for ratings. We expect the recovery to pre-2020 credit metrics to be uneven, and the credit impact of the pandemic to linger for some issuers, with credit metrics in the out-of-home entertainment and hotel industries next expected to broadly recover until 2023.

Market Demand May Never Be Higher

Ample liquidity has been available to speculative-grade issuers while economic activity recovers from the 2020 recession. Speculative-grade debt issuance during the second quarter reached $311 billion, a new record for second quarter issuance, and follows a record-setting surge in issuance during the first quarter. The surge in speculative-grade debt issuance is driven by both leveraged loans and speculative-grade bonds, with issuance levels for the combined total at an all-time high year-to-date (see chart 7). Through July, speculative-grade debt issuance has already exceeded the 2019 and 2020, and is less than $20 billion short of the full-year total for 2018.

Chart 7

Much of this recent surge in speculative-grade issuance has been used to refinance existing debt on better terms through lower interest rates and longer maturities. This has pushed out the refinancing wall, leaving little maturing debt left to come due in the next 18 months (see chart 8). Through 2022, only $222 billion in outstanding speculative-grade debt is coming due, and more than half is rated 'BB'. This isn't even one-third of the total speculative-grade debt issued in 2021 thus far, leaving very little refinancing risk outstanding.

Chart 8

The relative risk of holding corporate bonds can be a major contributor to future defaults because of the marginal pressure on cash flow when an issuer needs to refinance maturing debt. The U.S. speculative-grade corporate spread indicates future defaults based on a roughly one-year lead time (see chart 9). At the 357 bps, the speculative-grade bond spread implies a 2.1% default rate by June 2022.

Chart 9

While the speculative-grade spread is a good indicator of broad market stress in the speculative-grade segment, defaults are generally rare during most periods 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 in the credit and economic cycles (see chart 10).

Chart 10

The distress ratio (defined as the number of distressed credits, or speculative-grade issues with option-adjusted composite spreads of more than 1,000 bps 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. The distressed market has proved to be an especially good predictor of defaults during periods of more favorable lending. As a leading indicator of the default rate, the distress ratio has a relationship broadly similar to the overall speculative-grade spread, but with a nine-month lead time as opposed to one year. The 2.6% distress ratio in July corresponds to a 1.9% default rate for April 2022.

Market Optimism Is Supported By Economic And Financial Metrics

Using the VIX, the currency component of M1 plus demand deposits, and the ISM purchasing managers' index, we estimate at the end of June, the speculative-grade bond spread in the U.S. was about 50 bps below the implied level (see chart 11). Investor optimism around the outlook for businesses and the trajectory of the U.S. economy following the 2020 recession has been warranted.

Chart 11

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 2% in June 2022 (39 defaults in the trailing 12 months) in our optimistic scenario and 5.5% (108 defaults in the trailing 12 months) in our pessimistic scenario.

We determine our forecast based on a variety of factors, including our proprietary analytical tool for U.S. speculative-grade issuer defaults.   The main components of the analytical tool 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).

In addition to our quantitative frameworks, we consider current market conditions and expectations.   Factors we focus on 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

• "Economic Research: U.S. Real-Time Data: Consumers Are Weary Of A COVID Resurgence Amid A Recovering Labor Market," Aug. 13, 2021
• "Credit Trends: U.S. Distress Ratio Rises Slightly To 2.6% After 16-Month Decline," Aug. 5, 2021
• "Credit Trends: Risky Credits: U.S. And Canadian ‘CCC’ Issuers Drop Below Two-Year Average As Defaults Plunge," Aug. 3, 2021
• "2020 Annual Global Corporate Default Study And Rating Transitions," April 7, 2021