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 low, reaching 1.5% in December 2022 (see chart 1).   The default rate remained near its all-time low in January at 0.4%, with only five defaults in the index over the trailing 12 months. In our base-case scenario, approximately 18 issuers default (because of missed payments, bankruptcy filings, or downgrades to 'D' by S&P Global Ratings) in the index in the 12 months beginning Jan. 1, 2022. Credit quality continues to rebound from the 2020 recession, and we expect further deleveraging among our corporate issuers with S&P Global economists forecasting continued above-trend economic growth over the next two years. Index upgrades outpaced downgrades 2-to-1 in 2021, and in January the proportion of index issuers rated 'CCC'/'C' dropped to 7%, the lowest level since second-quarter 2019. Even so, the credit recovery has slowed somewhat in recent months, and the proportion of issuers in the index rated 'B-' is high at 31%, barely below the peak seen during the global financial crisis. We expect credit will continue to broadly recover in 2022 on strong economic growth, but defaults are all but certain to increase from historically low levels as risks build, growth decelerates, and financing conditions tighten.

In our optimistic scenario, the default rate reaches 0.75% in December 2022.   In this scenario, about nine issuers default over the 12 months that began Jan. 1, 2022. The recovery in issuer credit quality, credit market indicators, and default trends--including the increased frequency of selective defaults--all suggest that the default rate will remain low over the next 12 months (most selective defaults aren't counted in the index default rate; see "Differences In Default Rate Measurements" section below). In this scenario, the impact of the Russia-Ukraine conflict is more muted, and the Fed engineers a path to a soft landing after it substantially tightens policy, with economic growth remaining robust as inflation slows. This opens the door for more dovish forward guidance in the second half of the year and a relatively more modest tightening in financial conditions.

In our pessimistic scenario, the default rate spikes to 3.5% in December 2022.   In this scenario, approximately 41 issuers default over the 12 months that began Jan. 1, 2022. While in our base scenario we expect the Fed to substantially tighten policy in 2022, we assume the growth path for the economy will not be meaningfully lowered amid emerging risks, tighter policy, and high inflation. If growth sharply decelerates in 2022 and inflation persists as short-term rates quickly rise, then pressure on issuers could compound--interest expense on existing debt would increase, margins could be squeezed by higher costs and weaker demand, balance sheet liquidity could become constrained, and financial conditions could become restrictive. The rating distribution in the index implies default risk will remain relatively high, with 37% of issuers rated 'B-' or lower. Issuers rated 'B-' or lower in industries that are most vulnerable--consumer products, media and entertainment, retail/restaurants, aerospace, automotive, and health care--represented 12% of the index in January. In this scenario, a shock would push about one-fifth of these into default.

The Transition To SOFR Is Going Smoothly So Far

The transition away from LIBOR has gone off without a hitch so far, with nearly all the $104.7 billion of leveraged loan issuance priced through Feb. 11, 2022 referencing the secured overnight financing rate (SOFR), and with most of these issues incorporating credit spread adjustments (CSA). Outstanding loans may continue to reference LIBOR until the June 2023 deadline, and while the transition to an alternative benchmark rate has begun, LIBOR will be around a bit longer.

The interest rate tightening cycle is set to begin in March, and market pricing suggests that benchmark rates for leveraged loans will move sharply higher by year-end. Markets have priced in six or more 25 basis point (bps) Fed rate hikes in 2022, and three-month LIBOR pricing already reflects rates rising from near zero (see chart 2). If future rate increases are correctly priced into the U.S. yield curve, three-month LIBOR will rise by at least 125 bps by the end of the year.

Chart 2

What higher rates mean for our rated issuers in the Leveraged Loan Index varies. About three-fifths of loans in the index have LIBOR floors of 0-150 bps, with the average floor for the index at 43 bps (see table 1). If loans without floors are excluded, the average in the index increases to 72 bps. Floors tend to be higher for weaker-rated issuers and vary by industry, with the average floor for issuers rated 'CCC'/'C' in the index at 57 bps (99 bps excluding loans without floors). This suggests that the average cost of financing is essentially unchanged for loans in the index at this point, but further increases in benchmark rates would add to issuers' interest expense (assuming issuers have not locked in financing with interest rate swaps). This could pressure some issuers in the index, especially if we see growth sharply decelerate this year.

Even with tighter financial conditions imminent, new-issue institutional loan pricing suggests benchmark rates have some room to rise before financing conditions become restrictive (see chart 3). Total spreads for new-issue 'B+'/'B' institutional loans have remained low in February and new-issue yields would need to rise 150 bps before becoming restrictive. If the spread remained at the current level, rate hikes priced into the yield curve would push financing conditions into neutral territory in the second half of the year and near restrictive territory by year-end.

Chart 3

Loose Financing Conditions Are Boosting Debt Issuance

Ample liquidity and a search for yield pushed speculative-grade bond issuance to new records for a second consecutive year, and strong demand for floating-rate debt in 2021 drove leveraged loan issuance to new highs. Speculative-grade issuers took advantage of loose financing conditions by pushing out debt maturities and lowering their cost of financing, with debt maturing through 2023 less than one-third of the total issued in 2021.

Over two-thirds of leveraged loan issuance in 2021 was covenant-lite, with total covenant-lite issuance for the year ($563.5 billion) shattering the previous annual record. Investors were very comfortable moving down in credit quality, with 'B-' or lower debt issuance more than doubling in 2021 from the previous high in 2020 (see chart 4). Investor demand continued to drive strong 'B-' or lower leveraged loan issuance in January.

Chart 4

More than three-fifths of 'B-' or lower leveraged loan issuance in 2021 was for mergers and acquisitions (M&A) (see chart 5), largely concentrated in computers and electronics (29%), business services and leasing (13%), and health care (9%). The strong start for 'B-' or lower debt issuance this year was driven by a surge of leveraged loan issuance used for M&A in January. The heavy volume of recent M&A activity could spell weakness in the index should the economy sharply decelerate.

Chart 5

The Consumer's Financial Health Is In Focus

We are starting to see credit deterioration related to inflation and supply chain issues among our speculative-grade issuers, most notably in consumer products, where some issuers have reported weaker-than-expected results amid labor challenges, supply chains constraints, and higher costs In addition to high leverage, some of the affected issuers face liquidity challenges amid tighter working capital and high inventories. While we expect inflation and supply chain disruptions to abate somewhat, they will persist in 2022, and a slowdown in consumer spending would worsen the outlook.

Weak consumer spending would also dim the outlook for media and entertainment issuers, which improved recently. Several issuers reported better-than-expected results in the second half of 2021, with strong leisure spending on travel and entertainment in 2022 expected to support further deleveraging. Any disruptions from COVID-19 could also weaken the outlook for these issuers.

In the health care sector, disruptions from COVID-19 continue to weigh on issuers, with labor challenges and limited capacity for elective procedures pressuring margins. We are also seeing some pockets of credit deterioration related to supply chain issues. Increasing M&A in the sector will likely add to pressure on credit quality. If consumers' financial health weakens, we could see elective procedures be further delayed or cancelled, which would add to margin pressure.

In 2022, we may see real consumer spending slow as household savings are drawn down and discretionary income falls. Consumer price inflation continued to rise in January, reaching a nearly 40-year high, and high prices are weighing heavily on consumer sentiment, with the University of Michigan survey tumbling in February to its lowest level in over a decade. While household savings remained near all-time highs in third-quarter 2021, inflation is quickly eroding purchasing power, and growth in real average weekly earnings has been negative since last October. Soon, tighter monetary policy will add to the headwinds consumers face. While consumers would cheer for lower inflation, tighter monetary policy will likely slow wage growth, which has not broadly kept up with price increases to date despite a hot labor market. If supply-side pressures persist as rates rise, consumers could get squeezed.

Credit Markets Remain Sanguine, For Now

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 6).

The distress ratio for the cosmetics/toiletries industry fell about two percentage points over the past three months, but some issuers remain particularly weak.

Meanwhile, the distress ratio for the broadcast radio and television industry fell by about one percentage point, but transit and radio advertising still has a long road to recovery.

Notably, distress ratios spiked in the leisure and health care industries.

Chart 6

The Credit Recovery Has Slowed

Cumulative net rating actions in the index remain firmly negative after the rush of downgrades in 2020, and upgrade momentum has slowed in the past three months (see chart 7). The credit impact of the recession will linger as the economic recovery continues, and we expect the pace of upgrades in 2022 to remain muted relative to the pace of downgrades we saw in 2020.

The electronics/electric (31), health care (19), and chemical/plastics (17) industries had the most upgrades in the index in 2021.

Chart 7

The index remains susceptible to a shock due to the high proportion of issuers rated 'B-' or lower, which became elevated in 2019 and then spiked even higher in 2020 (see chart 8).

While the proportion of the index rated 'B-' remains very high, the proportion rated 'CCC'/'C' is no longer elevated. The proportion of issuers rated 'B-' or lower in the index will likely remain high in the near term as credit gradually recovers.

Chart 8

The electronics/electric industry accounts for 26% and 7% of 'B-' and 'CCC'/'C' issuer ratings in the index, respectively, or nearly one-quarter of issuers rated 'B-' or lower (see charts 9 and 10). Among all U.S. corporate technology issuers rated by S&P Global Ratings from 2010 to 2021, 21% 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.

Chart 9

Chart 10

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 2).

Table 2

Table 3

How We Determine Our Default Rate Forecasts

The S&P/LSTA Leveraged Loan Index default rate forecasts are based on recent observations and expectations for the path of the U.S. economy and financial markets. Among various factors, we consider our proprietary analytical tool for the S&P/LSTA Leveraged Loan Index issuer base. The main components of the analytical tool are the U.S. trailing-12-month speculative-grade corporate default rate, the ratio of selective defaults to total defaults, a leveraged loan debt-to-EBITDA ratio, the S&P/LSTA Leveraged Loan Index distress ratio, changes to the mix of rated loans toward higher or lower ratings, and the unemployment rate.

Related Research

• The U.S. Speculative-Grade Corporate Default Rate Could Reach 3% By Year-End As Risks Continue To Increase, Feb. 16, 2022
• U.S. Corporate Credit Quality Rebound May Be Losing Steam, Feb. 16, 2022