Chart 1

The health of American consumers remains key.   Thus far, interest rates have increased across the board--for Treasuries and investment-grade and speculative-grade corporate debt. Far from a flight to safety, this is perhaps more indicative of a normal shift away from fixed rate debt amid expectations for rising rates. The economy is still very healthy, but policymakers are arguably interested in staying ahead of a wage-price spiral. However, moving haphazardly risks harming consumer spending, which is key to sectors such as media and entertainment and consumer products. Together, these make up a large proportion of our current 'CCC'/'C' issuers--those most at risk of default, particularly if further COVID-19 variants stunt leisure-based activity (see chart 2).

We are starting to see some deterioration related to high inflation and supply chain issues, most notably in the consumer/service sector as some issuers have reported weaker-than-expected results.  In addition to high leverage, some affected issuers face liquidity challenges amid tighter working capital and high inventories. We expect inflationary pressures and supply chain disruptions to abate somewhat, but they will persist in 2022. A slowdown in consumer spending could worsen the outlook.

S&P Global Ratings Research expects the U.S. trailing-12-month speculative-grade corporate default rate to reach 3% by December 2022, from 1.5% at the end of 2021 (see chart 1).   Concerns over inflation and the pace of interest rate increases have been rising recently, but economic growth is expected to remain robust this year. On the credit side, the pace of speculative-grade upgrades outpaced downgrades by about 2.7-to-1 in 2021, with every sector now showing net upgrades. In aggregate, our outlooks and CreditWatches point to fewer downgrades ahead as well. Financing conditions have been showing some volatility recently, but this has largely been a normal response to higher expected rates rather than a flight to safety associated with an expected downturn. But risks are rising, and we are leaning toward more defaults in 2022--from the current 1.5% as of December 2021--as pandemic era supports are dialed back. Our baseline projection is still below the long-term average of 4%, and it is more likely any noticeable increase in defaults may occur in 2023 if these stressors continue or worsen.

In our optimistic scenario, we forecast the default rate could hit 1.75%.   In all instances, we expect the default rate to rise from its current 1.5%. This scenario projects a continuation of the decline in defaults that's been in place since second-quarter 2021, with some pickup later this year. Despite recent market stress and volatility, speculative-grade spreads have remained low and new issuance has not been meaningfully hampered. The economic recovery has been and is expected to remain strong. This scenario includes less time spent on anticipating Federal Reserve actions and market reactions, led by a decline in inflation allowing firms to more easily pass increased costs through with little systemic disruption.

In our pessimistic scenario, we forecast the default rate could rise to 6%.   Inflation has been increasing, with concerns that the Fed may have to tighten policy more aggressively than anticipated to successfully slow inflation--perhaps upending economic activity. Currently, it appears a majority of firms are able to pass through higher costs to consumers, but the gap between the Producer Price Index and the Consumer Price Index has been widening, potentially making further passthroughs more difficult. The market reaction has thus far pushed equities down and interest rates up, and if this trend continues or becomes more severe, financing conditions could tighten quickly. Some "late-cycle" behavior in the market such as increasing margin debt, record issuance, negative real yields, and about 90% of leveraged loans being covenant-lite may exacerbate the fallout from a population of issuers that is vulnerable to a shift in market sentiment.

Credit Recovery Continues But Remains An Uphill Climb

Although credit quality has improved in recent quarters, our ratings distribution remains weak among speculative-grade firms--about 35% of our speculative-grade ratings ('BB+' or lower) are 'B-' or lower (see chart 3). If investors' risk appetite declines as higher-quality debt becomes more attractive in nominal terms, weaker lending conditions could eventually strain some low-rated issuers. It is more likely that it will take some time before we see noticeable stress in financing conditions lead to more defaults. Our base case acknowledges more stress in the system relative to a quarter ago, but it may only nudge up the default rate to a slightly higher level in the near term, with the potential for more defaults in 2023.

Chart 3

The credit recovery continued in the fourth quarter. The speculative-grade negative bias fell two percentage points to 14%, with another one-point decline in January, to just over 13%. The speculative-grade positive bias remained near 11% in the fourth quarter, the highest level for the positive bias since second-quarter 2011.

At the end of the fourth quarter, only seven sectors had a negative net bias, down from eight in the third quarter and 13 when the year began. All 13 sectors had positive net rating actions during the fourth quarter (see chart 4).

Chart 4

Based on trends in rating actions and net bias, the speculative-grade credit recovery following the 2020 recession has been the fastest since 1995 (see chart 5). In the fourth quarter, the speculative-grade net bias improved to its highest level since 2011. Of the speculative-grade issuers that began the fourth quarter with a negative outlook or on CreditWatch negative, 15% had outlook or CreditWatch placements revised (back to stable or higher) without being downgraded, compared to just 6% that were downgraded. Even as we saw a record number of speculative-grade upgrades in 2021, the credit recovery remains an uphill climb given the surge of downgrades in 2020.

Chart 5

2021 Ended With Largely Supportive Indicators And Rising Stress

Measures of economic and financial conditions in the fourth quarter continued to reflect the strong rebound in economic growth and the availability of ample liquidity (see table 1). The Fed survey on lending conditions (for fourth-quarter 2021) rose to -14.5 in January but still indicates loose lending standards. Lending standards for small firms also remained accommodative (-9.4).

We continue to see more frequent periods of market volatility, with the VIX hitting 30 during December and January. However, this volatility largely skirted the speculative-grade bond market and credit markets shrugged off episodes of volatility during the year. The speculative-grade credit spread ended the year at 351 bps after seeing some earlier widening in November. There has arguably been more volatility thus far in 2022 as markets react to incoming economic data and Fed statements.

Improvements in economic and financial data have moderated as tailwinds have faded and modest headwinds to global economic growth have formed. There remains some downside risk to our base-case default rate assumptions, which are relatively benign, historically.

Table 1

Defaults Ticked Up In The Fourth Quarter

Defaults had fallen steadily since the second quarter of 2020, hitting a low in the third quarter of 2021 before ticking up in the fourth quarter (see chart 6). At year-end, the trailing-12-month speculative-grade corporate default rate had plummeted to 1.5%, its lowest level since 2013.

Defaults in the fourth quarter were concentrated among real estate (four) and forest and building products/homebuilders (one). In our research, the U.S. region includes the tax havens of Bermuda and the Cayman Islands, and in the fourth quarter several Chinese property developers incorporated in the Cayman Islands defaulted on missed principal/interest payments (Fantasia Holdings Group Co. Ltd., Sinic Holdings Group Co. Ltd., China Aoyuan Group Ltd., and China Evergrande Group).

Property developers in China have faced increasing difficulty accessing funding and disposing of assets, with insufficient liquidity leading to negative rating actions. Excluding defaults from Chinese property developers, defaults were flat between the third and fourth quarters.

Chart 6

Most Sectors See A Drop In The Number Of 'CCC'/'C' Ratings

Credit quality has been improving. However, it's still far worse than it was pre-pandemic since upgrades in 2021 didn't make up for the large number of downgrades in 2020. Still, there have been a large number of ratings raised out of 'CCC'/'C', lowering most sectors' proportion of these lowest-rated issuers, even during a low default period (see chart 7).

Chart 7

The proportion of speculative-grade issuers rated 'CCC'/'C' fell to 9%, down from the all-time high of 17% seen in May 2020 but higher than the 8% at the end of 2019. Since 2010, the average proportion of speculative-grade issuers rated 'CCC'/'C' in any given month was 7%. There were 170 'CCC'/'C' issuers entering 2022, led by consumer/service (42), leisure time/media (36), and aerospace/automotive/capital goods/metal (35).

Outlooks for media and entertainment issuers have improved, with several issuers reporting better-than-expected results in the second half of the year, and as strong leisure spending on travel and entertainment is expected to support companies in lowering their leverage in 2022. Risks to the outlook for the sector include COVID-19 disruptions and a protracted slowdown in real consumer spending.

Outlooks for oil and gas issuers have improved as higher energy prices support companies in lowering leverage. The improved outlook even extends to the oilfield services industry, with high prices, tight inventories, and limited spare production capacity expected to support higher exploration and production spending in 2022. Risks to the outlook for the sector include COVID-19 impacts on demand and changing assumptions for either OPEC+ or North American production.

Favorable Financing Propels Issuance To Record High

Speculative-grade issuers have had access to ample liquidity as economic activity has rebounded from the 2020 recession and the Fed has maintained loose monetary policy. This has resulted in a record haul for high-yield bond and leveraged loan issuance in 2021, hitting a breakthrough total of $1.2 trillion (see chart 8). Speculative-grade debt issuance slowed somewhat in the second half of 2021 but still hit records in the third and fourth quarters.

As rates are expected to rise, we anticipate fixed-rate high-yield bond issuance will contract this year, while demand for leveraged loans should stay strong, even if not at the same level as in 2021.

Chart 8

Companies have used much of this recent surge in speculative-grade issuance to refinance existing debt through lower interest rates and longer maturities. This has pushed out refinancings, leaving little debt left to come due in the next two years (see chart 9). Through 2023, only $363 billion in outstanding speculative-grade debt is maturing--less than one-third the total issued in 2021. That said, maturing debt from 2024 onward is heavily tilted toward floating-rate loans, which would be harder to service as rates rise.

Chart 9

The relative risk of holding corporate bonds can be a major contributor to 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 defaults based on a lead time of roughly one year (see chart 10). At 351 basis points (bps), the speculative-grade bond spread implies a 2% default rate by December 2022.

Chart 10

While the speculative-grade spread is a good indicator of broad market stress in the speculative-grade segment, defaults are generally rare during most points in the economic cycle, outside of downturns. 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 defaults across all points in the credit and economic cycles (see chart 11).

Chart 11

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 those issuers perceived as facing extraordinary stress, even in relatively benign periods. It has proved to be an especially good predictor of defaults during periods of more favorable lending conditions. As a leading indicator of the default rate, the distress ratio shows a relationship that is broadly similar to the speculative-grade spread, but with a lead time of nine months as opposed to one year. The 2.6% distress ratio in December corresponds to a 1.9% default rate for September 2022.

Some Spread Widening Is Expected In 2022

Using the VIX, the ISM purchasing managers index, and components of the M2 money supply, we estimate that at the end of December the speculative-grade bond spread in the U.S. was about 71 bps below our estimate (see chart 12). As the economy begins to decelerate toward trend growth and monetary policy tightens in 2022, modest spread widening may be warranted. Rising market volatility in response to incoming economic data and speculation over the appropriate amount of rate increases will likely produce further widening in the estimated spread in the near term.

Chart 12

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 1.75% in December 2022 (34 defaults in the trailing 12 months) in our optimistic scenario and 6% (116 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 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: Solid Job Gains, Surging Prices Fuel The Fed's Policy Rocket, Feb. 11, 2022
• Default, Transition, and Recovery: The U.S. Distress Ratio Remains Low But May Rise As Financing Costs Increase, Feb. 7, 2022
• Industry Top Trends 2022: Consumer Products, Jan. 25, 2022
• Industry Top Trends 2022: Media and Entertainment, Jan. 25, 2022
• Economic Outlook U.S. Q1 2022: Cruising At A Lower Altitude, Nov. 29, 2021
• Credit Trends: The Economic Impact Of Default Is Falling As Selective Defaults Rise, Sept. 16, 2021
• Default, Transition, and Recovery: 2020 Annual Global Corporate Default And Rating Transition Study, April 7, 2021