Chart 1

S&P Global Ratings Research expects the S&P/LSTA Leveraged Loan Index trailing-12-month default rate (by number of issuers) to remain near previous cycle lows and reach 1% in September 2022 (see chart 1).   The default rate fell to 0.4% in October, just slightly above the all-time low for the index. In our base-case scenario, approximately 12 issuers default (because of missed payments without forbearance, bankruptcy filings, or downgrades to 'D' by S&P Global Ratings) in the index over the 12 months that began Oct. 1, 2021. Third-quarter headwinds led us to revise our forecast for U.S. economic growth in 2021 lower, but we still expect growth to reach a 37-year high this year and remain above long-run trend growth through 2023. We expect the credit recovery will continue to face an uphill climb in 2022, but highly leveraged issuers have generally been able to exploit favorable lending conditions and shore up short-term liquidity with strong speculative-grade debt issuance in 2020 and issuance that shattered records in 2021. The weakest-rated issuers in the index will need to position for stronger growth and reduce leverage over the next few years as we expect financial conditions to marginally tighten. But near-term liquidity risk is generally low and points to few defaults in the index over the next 12 months.

In our optimistic scenario the default rate remains near the all-time low and reaches 0.5% in September 2022.   In this scenario, about six issuers default over the 12 months that began Oct. 1, 2021. Credit market indicators and default trends, including the increased frequency of selective defaults, suggest that the index default rate will remain near cycle lows over the next 12 months (most selective defaults aren't counted in the index default rate; see section below).

In our pessimistic scenario the default rate spikes to 2.5% in September 2022.   In this scenario, 29 issuers default over the 12 months that began Oct. 1, 2021. Repricing of either growth, inflation, or monetary policy assumptions, resurgence of COVID-19, or geopolitical friction are some of the possible catalysts for a negative credit impulse over the next 12 months. The rating distribution in the index implies default risk is relatively high with 37% of issuers rated 'B-' or lower. Issuers rated 'CCC/C' in industries that were disproportionately affected during the 2020 recession--within the oil and gas, consumer products, media and entertainment, retail/restaurants, aerospace, and transportation sectors--represented 4% of the index in October; in this scenario a shock would push more than one-third of these into default.

The Credit Recovery Is In An Uphill Climb

Rating actions since fourth-quarter 2020 reflect improved liquidity on issuer balance sheets, better performance, and the strong economic recovery.

In 2021 we have already seen 'B-' and 'CCC/C' rated debt issuance that shattered the previous annual record set just a year earlier in 2020 (see charts 2 and 3). The surge in speculative-grade debt issuance that began in second-quarter 2020 following the Federal Reserve's expansion of its credit facilities to support fallen angel debt and high yield bond ETFs has mitigated defaults following the 2020 recession by allowing weaker-rated issuers to shore up short-term liquidity and long-term financing.

On average, among all U.S. corporate issuers rated by S&P Global Ratings from 2010 to 2020, 30% and 4% of those rated 'CCC/C' and 'B-' respectively defaulted within one year. For comparison, just 14% and less than 1% of all U.S. corporate issuers that were rated 'CCC/C' and 'B-' respectively as of October 2020 have defaulted. This divergence is in large part a reflection of the abundant liquidity available to these issuers. We expect this relationship to revert to the long-term trend as financing conditions normalize.

Chart 2

Chart 3

As financing conditions remained extraordinarily accommodative for speculative-grade borrowers, U.S. economic growth also gained momentum in the first half of 2021 after the improved vaccination outlook led to a faster reopening of the economy, and $2.8 trillion in fiscal stimulus further boosted growth. As a result, liquidity and growth concerns around many 'B-' and 'CCC/C' rated issuers resolved, and nearly half that began the year with either a negative outlook or on CreditWatch negative have had outlooks revised higher without being downgraded; of those with positive rating actions, half were upgraded and half were outlook revisions only.

Supply-chain disruptions are constraining economic activity and contributing to surging inflation. This, combined with a COVID-19 resurgence during the third quarter, stalled momentum in the U.S. economy, as real GDP dropped to an annual rate of 2.0% from 6.7% in second-quarter 2021.

We see some reasons for optimism heading into 2022, however, with early signs that supply-chain pressures are easing (see "U.S. Real-Time Data: Early Signs Indicate Supply-Side Pressures Are Easing"), and the strong labor market and retail sales reports for October signal that economic activity is firming in the fourth quarter (see "U.S. Biweekly Economic Roundup: Job Gains Pick Up As Labor Force Participation Fails To Improve").

The year has been overwhelmingly positive for speculative-grade credit, especially leveraged loans driven by demand from CLOs--which have had record issuance this year. But with the rush of downgrades following the 2020 recession, cumulative net rating actions in the index since the beginning of 2020 remain firmly negative, and upgrade momentum has stalled over the past four months (see chart 4). We expect the credit impact of the recession to linger and the pace of upgrades in the index to remain muted in 2022 relative to the pace of downgrades in 2020.

The electronics/electric (28), health care (18), and chemical/plastics (17) industries lead all industries with the most upgrades in the index year to date, and together these industries account for over one-third of upgrades in 2021.

While the industries that were disproportionately affected by the 2020 recession accounted for over half of 2020 downgrades in the index, they account for just over one-third of upgrades this year. We expect the credit recovery to continue into 2022 and 2023 for many of these issuers.

Chart 4

The index remains susceptible to a shock due to the high proportion of issuers rated 'B-' or lower. The proportion of issuers rated 'B-' or lower in the index became elevated during 2019 and then spiked even higher when the 2020 recession began (see chart 5).

While the proportion of the index rated 'B-' remains high, the proportion rated 'CCC/C' is just somewhat elevated.

The proportion of the index rated 'CCC/C' has fallen 7 percentage points from its recent peak to 8% while the proportion of issuers rated 'B-' has fallen just 1 percentage point to 29%. We expect the proportion of issuers rated 'B-' or lower in the index to remain high in the near term as credit continues a gradually recovery.

Chart 5

Sector Default Trends Vary

The electronics/electric industry accounts for 26% and 10% of 'B-' and 'CCC/C' issuer ratings in the index respectively, or nearly one-quarter of issuers rated 'B-' or lower (see charts 6 and 7). Among all U.S. corporate technology issuers rated by S&P Global Ratings from 2010 to 2020, 22% and 1% of those rated 'CCC/C' and 'B-' respectively defaulted within one year, which is meaningfully lower than the average for all rated U.S. corporate issuers during that span.

With such a large proportion of the 'B-' and 'CCC/C' index ratings in the electronics/electric industry, the index may be somewhat less susceptible to a shock than is suggested by the high proportion of 'B-' or lower ratings in the index alone.

Nonetheless, the ratings mix in the index still suggests default risk is high, and in our pessimistic scenario, we see the default rate spiking to 2.5%. Issuers rated 'B-' and 'CCC/C' in the industries that felt the brunt of the 2020 recession accounted for 6% and 4% of the index respectively in October, and in this scenario about one-fifth of these 'B-' or lower issuers default.

Chart 6

Chart 7

The credit impact of the 2020 recession will linger, and the recovery for weaker-rated issuers in the industries that were disproportionately impacted will extend into 2022 or later.

The outlook for issuers in the media and entertainment sector has substantially improved as advertising trends strengthened and in anticipation of a sustained pick-up in spending on travel, entertainment, and lodging.

But we expect the recovery to pre-2020 credit metrics to be uneven in the sector, with credit metrics in the out-of-home entertainment and hotel industries not expected to broadly recover until 2023. The pace of recovery in these industries was modestly slowed by the spread of the delta variant during the third quarter, and additional waves of infections remain a headwind.

Outlooks in the retail/restaurants and consumer products sectors substantially improved in 2021 with strong consumer spending as the vaccine rollout led to eased restrictions on businesses.

Even so, we don't expect credit metrics for issuers in discretionary retail and discretionary consumer products to broadly recover until 2022. Inflationary pressures and supply chain constraints could push the timeline for recovery out some.

The outlook for the oil and gas sector has improved as OPEC+ supply cuts continue to support oil prices even amid a strong recovery in demand. We don't expect credit metrics in the oil and gas sector to broadly recover until 2022. However, we have revised our near-term West Texas Intermediate (WTI) oil price assumptions higher, which could pull the timeline for recovery forward somewhat.

Most Industry Distress Ratios Are Low

Distress ratios rise when debt securities become illiquid in the market due to near-term credit concerns, causing spreads to sharply widen. Generally, high distress ratios reflect deterioration in market confidence that issuers will repay debt. The distressed pricing of illiquid debt securities also often reflects weak short-term liquidity at the issuer level (e.g. uses of liquidity over the next 12 months that exceeds sources and limited ability to refinance or issue new debt). High distress ratios may precede a default or they may be resolved through refinancing, new debt issuance, or debt restructuring.

Only a handful of industries have high distress ratios (the percentage of performing loans priced below 80 cents on the dollar), and the industries exhibiting the most distress (cosmetics/toiletries and broadcast radio and television) have few issuers rated 'B-' or lower, likely limiting their contribution to defaults over the next 12 months (see chart 8).

Still, credit metrics for issuers in the cosmetics/toiletries industry aren't expected to broadly return to 2019 levels until 2022. The distress ratio for the industry fell 11 percentage points over the past three months, but some issuers remain in particularly weak positions.

Meanwhile, credit metrics for some issuers in the broadcast radio and television industry are also unlikely to recover until 2022 or later; we expect advertising spending to easily recover past 2019 levels this year, but growth for local media has been uneven, with transit and radio advertising facing a longer road to recovery.

A few other industries have somewhat elevated distress ratios. Of these, the automotive industry has a relatively high number of 'B-' or lower issuers. The impact of the 2020 recession is expected to linger for the industry as supply-chain constraints continue to pressure operations; issuer credit metrics are not broadly expected to recover until 2023.

Chart 8

Tighter Financial Conditions Will Follow Tighter Monetary Policy

The fiscal and monetary policies implemented in 2020 in response to the pandemic-induced recession have resulted in extraordinarily easy financial conditions in 2021.

Given the record debt issuance since the pandemic began in 2020, weaker-rated issuers have pushed out debt maturities, lowered their interest expense, and bought time. The supportive policies following the 2020 recession and strong economic recovery could lead to substantial improvements in credit fundamentals. However, we expect the credit impact of the recession will linger for some time. As monetary policy and financial conditions tighten over the next few years, deleveraging will be in focus.

The Fed will begin tapering asset purchases this month, with new purchases falling to zero by June 2022. This implies that the balance sheet will grow to around $9 trillion (about 37% of GDP compared to 19% at year-end 2019). As the growth rate of the balance sheet slows, monetary policy will become marginally tighter.

With inflation continuing to surge in the fourth quarter, the first federal funds rate hike may come earlier than previously expected. High inflation has continued to weigh on consumer confidence, but so far retail sales have remained strong. Even so, the headwinds to growth that stalled economic momentum in the third quarter and high inflation bear watching. Markets now price in Fed rate hikes as early as mid-2022, and we have pulled forward our expectation for the first federal funds rate hike to September 2022 (previously expected in December 2022).

Differences In Default Rate Measurements

The high proportion of selective defaults in the U.S. has kept the broader speculative-grade corporate default rate higher than the Leveraged Loan Index default rate. This is because the definition of default for the Leveraged Loan Index is much narrower.

There are differences in the definitions of default for each default rate series and forecast we analyze in our reports. The S&P Global Ratings definition of default determines the U.S. trailing-12-month speculative-grade corporate default rate.

S&P Global Market Intelligence's Leveraged Commentary & Data's (LCD) definition of default determines the S&P/LSTA Leveraged Loan Index trailing-12-month default rate by number of issuers. This definition of default only includes defaults on loan instruments and excludes selective defaults from distressed debt exchanges. The differences in default definitions are important sources of variation between the two series (see table 1).

Table 1

Table 2

Related Research

• The U.S. Speculative-Grade Corporate Default Rate Could Reach 2.5% By September 2022, Nov. 16, 2021
• U.S. Corporate Credit Recovery Remains An Uphill Climb, Oct. 28, 2021
• U.S. Real-Time Data: Supply Chain Disruptions Slow The Pace Of Economic Growth, Oct. 29, 2021