Chart 1

Baseline: S&P Global Ratings Research expects the European trailing-12-month speculative-grade corporate default rate to fall to 3.25% by June 2022 from 4.7% as of June 2021 (see chart 1).  In July, our economists revised upward their GDP projections for the eurozone for this year and next, setting the foundation for declining default rates among speculative-grade credits (see "European Economic Snapshots: The Economy Is Responding Quickly To The Grand Reopening"). Factors supporting growth include increasing vaccination rates, continued policy supports, and the potential impact of the EU Next Generation plan. Credit trends have also improved this year. Through June, there have been more speculative-grade upgrades than downgrades, and the declining proportion of issuers with negative outlooks or ratings on CreditWatch negative also point to fewer defaults in the future. Still, obstacles remain for sectors dependent on in-person interaction (hotels, gaming, and 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 near to medium term.

Optimistic scenario: The default rate could fall to 2%.  In addition to the many positive economic and credit indicators forming our base case, our optimistic scenario considers that markets remain very supportive of speculative-grade issuers in 2021, with exceptional demand for high-yield debt in the search for yield. Risk pricing on current speculative-grade bonds and leveraged loans and a declining portion of distressed leveraged loans reflect ample, if not excess, market liquidity and optimism. These conditions also indicate that the default rate could fall even further. Expansive monetary support during the pandemic has helped push borrowing costs to new lows (into negative territory in some cases), and market pricing largely reflects that investors believe policy tightening is still some time away.

Pessimistic scenario: The default rate could rise to 5.5%.   Our pessimistic scenario considers that the mix of speculative-grade ratings remains weak (see chart 2). Just under one-third of the speculative-grade issuers we rate are 'B-' or lower, leaving the region vulnerable to a disruptive shock. And there are several possibilities that could slow progress, including virus mutations, unexpected policy missteps, and financing conditions. The EU may import tighter financing conditions from the U.S. if the Federal Reserve moves earlier or more than expected. In addition, if pent-up consumer savings remain unspent, this would crimp the recovery in corporate revenues. The 'CCC/C' population of issuers in Europe is heavily concentrated in sectors that were hardest hit by the pandemic, such as media and entertainment, which alone accounts for 36%. We anticipate it will take several years for these weaker sectors to return to their 2019 credit metrics. A sharp rise in interest rates alongside any further lockdowns that disrupt the economic recovery would be especially difficult on these weaker-rated issuers as they try to recover from the disruption experienced in 2020.

Chart 2

Credit Metrics Show Steady Improvement

After downgrades outpaced upgrades by nearly eight-to-one in 2020, speculative-grade upgrades have exceeded downgrades year to date by almost two-to-one (see chart 3). Despite the recent improvement, the large number of downgrades last year still casts a shadow. Since the start of 2020, speculative-grade downgrades still outnumber upgrades (353 to 106). That said, the negative bias on speculative-grade issuers in June (24.9%) fell to almost half the value from last June (48.2%). Vaccine progress, the easing of pandemic restrictions on economic activity, ample liquidity, and the strong market appetite for yield are all contributing to improved credit metrics.

Chart 3

Still, this easing of downgrades has varied across sectors (see chart 4).

The overall speculative-grade net rating actions (the upgrade rate minus the downgrade rate) improved significantly in second quarter, to only negative 1.8% in the 12 months ended in June 2021, from negative 17.5% through March. But the overall reading may mask significant variability across sectors. Among all, the leisure and media sector remains the weakest, at negative 16% net rating actions. Others, such as consumer services--the largest sector in Europe--are now seeing a slight advantage in net upgrades (3%). Net bias improved for most speculative-grade sectors as well; however, this is where leisure lags the most, with a net ratings bias of negative 46%, compared with an overall speculative-grade net bias of negative 16%.

Chart 4

The relative rating distributions across sectors vary as well (see chart 5). The media and entertainment sector, which made up 13.4% of speculative-grade corporate credits at the end of June, has the largest concentration of 'CCC/C' ratings at 30.4%, followed by the oil and gas and transportation sectors at 29.2% and 26.3%, respectively. This leads us to believe that some sectors will contribute more defaults than others. It will likely take longer for these sectors' financial positions to recover, and they could increase the default tally. We largely expected this divergence to happen, which is consistent with our expectation for a K-shaped economic recovery over the next few years.

Chart 5

In the 12 months ended June 2021, we saw a massive improvement in credit momentum and expectations (see chart 6). When looking at net rating actions, the negative 1.7% reading for the period was a significant reduction from the negative 17% reading in the 12 months ended March 2021. This marked reduction was not unexpected, as the large swath of downgrades in the second quarter of 2020 have been removed from the trailing-12-month window.

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 second-quarter 2021 would suggest the default rate should fall in the near term as well, particularly if the policy retraction proceeds in an orderly fashion, as expected.

Most European defaults through July resulted from distressed exchanges (77%; see chart 7).

In our default statistics and forecast, we include both selective default ('SD') and default ('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 seven months of 2021, 77% of European defaults were distressed exchanges, while there have been no bankruptcies or insolvencies so far.

Chart 7

The pace of defaults so far in 2021 has been more modest compared with 2020. Through July, there have been 13 defaults in Europe, three of which occurred in the second quarter. If this were to continue for another three quarters, it would produce only an annualized 1.1% default rate. While markets still appear to support new debt, it is important to consider that 74% of all distressed exchanges are ultimately followed by additional default events.

Markets' Drive For Yield Has Kept Defaults Low And Borrowing High

Despite lingering risks related to the still-high number of lower-rated issuers, fixed-income markets are reflecting modest default expectations. Debt issuance took off through July, and the 2021 speculative-grade debt total already exceeds the full-year totals since 2018 (see chart 8). Combined high-yield bond and leveraged loan issuance totaled €220 billion through July compared with €124 billion at the same time last year. June alone added €36.9 billion, second only to the €43.5 billion from March.

Chart 8

Financing conditions on loans to enterprises (as measured by the European Central Bank's Euro Area Bank Lending Survey) reflect easing conditions for the first time since the third quarter of 2019, albeit by only a very small net percentage (see chart 9). Still, the net easing of 1.13% on loans to all enterprises by size is a noticeable decline from the 25% net tightening reading only two quarters prior. Looking at projections for the second quarter, banks expect lending conditions to tighten by only a net 2% rate.

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 fallen after rising sharply in early 2020. The speculative-grade bond spread has stabilized at a level even below where it began 2020, to roughly 300 basis points (bps) since March.

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 3.25% is 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 pandemic, bond investors have been more optimistic than the underlying economy and financial markets have implied. This is likely due to the extraordinary levels of monetary, fiscal, and regulatory support by authorities. And this has been carried over into 2021. Using a framework 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 240 bps above our estimation of 55 bps (see chart 11).

This is not to imply that the speculative-grade spread should be exactly 55 bps. In recent months, the European Commission's EU Industrial Confidence Indicator has set new all-time highs each month since April. This is an input into our estimation and reflects a marked improvement in the larger economy, rather than a low point in market volatility or an infusion into the money supply.

Chart 11

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.

Related Research

• Credit Trends: Risky Credits: Europe's 'CCC' And Below Corporate Ratings Tally Remains Elevated, Aug. 2, 2021
• Leveraged Finance: European Leveraged Finance And Recovery Second-Quarter 2021 Update: Late Cycle Behavior Or A Brave New World?, July 20, 2021
• European Economic Snapshots: The Economy Is Responding Quickly To The Grand Reopening, July 9, 2021
• Economic Research: Early Momentum Boosts The U.K. Recovery, June 24, 2021
• European Corporate Support Schemes: Extending And Amending, April 30, 2021