Selective Defaults Have Become More Frequent Since The Financial Crisis

Selective defaults--a default by an obligor which we feel has selectively defaulted on a specific issue or class of obligations but will continue to meet its payment obligations on others in a timely manner--have become a larger proportion of all defaults in the U.S. since the global financial crisis (GFC; see chart 1). In fact, since 2016, the ratio of the selective default rate to the overall rate has averaged 51%, and it reached an all-time high in June, at 57%.

Chart 1

In Europe, this shift to selective defaults happened during the GFC as well--and to an even greater extent (see chart 2). Twice--in the summer of 2010 and the first three months of 2016--there were 12-month periods in which all defaults in Europe were selective defaults. Since 2011, the proportion of the overall speculative-grade default rate attributable to selective defaults has averaged 71%, finishing the 12-months-ended June 2021 at 76%.

In general, a higher proportion of selective defaults in Europe is to be expected. The bankruptcy process is typically more costly or punitive for business owners in Europe than for those in the U.S. because there is no comparable Chapter 11 bankruptcy code in Europe, which allows companies to reorganize their business. Bankruptcies in Europe generally result in more liquidations than reorganizations, and the legal process tends to take much longer.

Chart 2

The Rise In Selective Defaults Is Led By Distressed Exchanges

One of the more popular forms of selective default in the post-GFC period has been distressed exchanges and other types of debt exchanges. We consider distressed exchanges as tantamount to default, resulting in the issue receiving a 'D' rating (default), and often the issuer credit rating being moved to 'SD' (selective default). The issuer credit rating could move to 'D' if we believe the restructuring is more generalized. For more detail on our criteria for treatment of distressed exchanges, see "S&P Global Ratings Definitions," Jan. 5, 2021.

In the U.S., there have been a few times in the last 13 years when the default rate of distressed exchanges has equaled or exceeded that of all other types of defaults--notably right after the GFC and today (see chart 3). Interestingly, the default rate of distressed exchanges lags that of all other types during large default cycles, or recessions, including the most recent one in 2020. That said, during the 2014-2016 period, which saw increased defaults among energy and natural resources, the default rate for distressed exchanges did the opposite: it led the default rate of all other types.

During periods of widespread economic stress such as recessions, it is more likely that the weakest firms will default first, and given their weaker finances, lenders are less likely to engage in a restructuring of their existing debt if they believe the firm will not have the liquidity or solvency to survive a prolonged downturn. In contrast, if a recession is believed to be over and the economy is on the rebound, residual financial stress could be more appropriately mediated via a distressed exchange if lenders believe renewed revenues are around the corner.

In the case of the 2014-2016 period, the opposite trend could have been a result of the belief by both issuers and investors in the commodities sectors that the fall in oil and metals prices at the time was going to be temporary. During this time, defaults in the U.S. were dominated by these sectors. This could have increased the tolerance for distressed exchanges in those sectors if the belief was that prices would rise before too long.

Chart 3

Similar patterns are also observed in Europe, but with distressed exchanges having an even larger impact on the overall default rate (see chart 4). Here, too, the peak default rate for distressed exchanges comes later than other types of defaults during major default cycles that typically happen around recessions. This lag in the distressed exchange-based default rate during widespread stress seems to come slightly later in Europe as well, at roughly six months.

Chart 4

Distressed Exchanges Carry Higher Recovery Rates

Our annual U.S. recovery studies have shown that ultimate discounted recovery rates on bonds that went through a distressed exchange are higher than recovery rates after bankruptcies. This has been true over the long term, but this difference has been accentuated in the last few years (see chart 5). In fact, since 2018, senior secured bonds have averaged a 75% recovery following a distressed exchange (22 percentage points higher than the average bankruptcy restructuring over the same period), and senior unsecured bonds have averaged a 67% recovery following a distressed exchange (more than 50 percentage points higher than the average bankruptcy restructuring over the same period).

Chart 5

Of course, recoveries on distressed exchanges can perhaps be more appropriately thought of as haircuts to bondholders. We have also observed that many selective defaults eventually lead to additional defaults later on, including bankruptcies (see "Out-Of-Court Restructurings May Lead To Repeat Defaults Among Distressed U.S. And Canadian Corporates," May 11, 2021). Since 2008, roughly 21% (203) of all the defaults in the U.S. have been repeat defaults--meaning the issuer has defaulted at least once before. Of those, over three-quarters are distressed exchanges (155). Of the repeat defaults that are distressed exchanges, 46 resulted in bankruptcy. This amounts to about 4.7% of all defaults observed since 2008. And many of these defaults following a previous distressed exchange have come from the energy and natural resources sector (36%). We have also observed that the average time between a distressed exchange and subsequent default (of any type) is just over two years, with a median time of 1.4 years.

Lower economic losses and higher recoveries for distressed exchanges, combined with an increasing percentage of the default total being attributable to distressed exchanges, implies that--on average--the full economic cost of default to lenders has been falling over time since the financial crisis.

Loose monetary policies by central banks in recent years, particularly pushing interest rates to zero or lower, have certainly encouraged more investors into riskier asset classes such as speculative-grade debt. However, a secondary factor could be the trend toward more selective defaults and distressed exchanges in recent years, which carry much higher recovery rates. Because we consider these events tantamount to default, our issuer credit ratings still reflect high probability of default for weaker issuers regardless of the ultimate type of default. If more defaults are coming from selective defaults and distressed exchanges, their higher recovery rates may also be supporting what appears to be an increasing risk appetite among investors in recent years--as opposed to just looking at issuance and rating distribution trends alone.

Table 1

Appendix: Data Methodology

The default rates presented here include those adjusted for selective defaults and by the default type. Our default rates include those by issuers who have had their ratings previously withdrawn but whose default events were public and broadly qualified as defaults under our general criteria. However, because we were not actively rating these issuers at the time of default, these events were recorded as 'D' ratings, even if they may have been considered 'SD' had we rated them at the time. This may slightly understate the full extent of selective defaults and distressed exchanges in their respective default rates presented.

We have included de facto restructurings, debt exchanges, debt restructurings, and distressed exchanges under our definition of distressed exchanges in the charts above.

The presentations and conclusions here are based on our long-term issuer credit ratings and do not include credit estimates. Because of this, we mostly focused on larger companies and generally excluded small and medium enterprises.

Related Research

• Out-Of-Court Restructurings May Lead To Repeat Defaults Among Distressed U.S. And Canadian Corporates, May 11, 2021
• S&P Global Ratings Definitions, Jan. 5, 2021
• U.S. Recovery Study: Clouds Loom As Defaults Rise, Dec. 7, 2020

Contributors: Abinash Meher, Lyndon Fernandes, Ryan Peet, and Jessica Templeton-Lynch.