Risks are becoming wider and deeper. Inflation and interest rates have been rising quickly since the start of the year, and the ongoing Russia-Ukraine conflict raises more uncertainties, which could result in prolonged disruptions to Europe ranging from energy sourcing, trade, and agricultural shortages in the months ahead. China's zero-Covid policy has disrupted, and will continue to disrupt, global supply chains.

Chart 1

We feel European speculative-grade issuers (rated 'BB+' and below) are less vulnerable to interest rate increases in the near term than in the U.S. (see chart 2), but more vulnerable to the various economic and geopolitical stressors. Given Euribor's current very low level and with many loans with floors of zero, combined with the European Central Bank's (ECB) comparable delay in raising rates, it may be some time before rising rates start to substantially affect speculative-grade loan issuers in Europe.

Chart 2

Baseline The European trailing-12-month speculative-grade corporate default rate rises to 3% by March 2023 from 0.7% as of March 2022

This forecast represents a noticeable increase, but also a relative return to the long-term average of 3.2%. Our economists have recently updated their expectations for eurozone GDP and inflation, with growth now expected to decline and inflation to expand faster this year. Markets have been pricing in more risk in recent weeks and expectations for the Russia-Ukraine conflict to end soon are giving way to a more prolonged conflict. The recent strength of European consumers will be crucial for issuers' continued ability to pass on higher costs, but both will be challenged more as the year progresses, particularly as energy costs rise. This will likely squeeze profit margins later in the year around the time the ECB starts to raise rates.

Optimistic scenario: We forecast the default rate will hit 1.25%

Thus far, firms have had relative success in passing through higher costs to consumers, who themselves have a surplus supply of wealth to fall back on in the face of rising inflation. Companies also have higher cash holdings than in recent years. Between companies and consumers, an optimistic outcome is possible if the Russia-Ukraine conflict ends in the next few months, sanctions are removed shortly thereafter, and inflation cools enough for a return of orderly reflation and a slower return to more "normal" monetary policies. This would all help the current below-trend pace of defaults to largely continue, if still increased from where it is currently.

Pessimistic scenario: We forecast the default rate could rise to 5%

Thus far, European firms have had relative success in passing through higher input costs while avoiding the a rising wages in the U.S. Consumers have likewise remained optimistic for the time being; however, if the Russia-Ukraine conflict and sanctions persist into the fall or escalate in severity, rising energy costs will cut into discretionary spending as home heating needs pick up, raising the possibility for a recession. The speculative-grade population is heavily tilted toward consumer-facing industries, though all may see profit margins challenged as these stressors linger.

Issuance Plummets And Spreads Start To Widen As Market Volatility Rises

Market volatility so far this year has kept issuers and investors largely on the sidelines. Combined leveraged loan and high-yield bond issuance has fallen off markedly, posting a year-to-date total of only €48 billion through April (see chart 3). This is well below 2021's record pace, but also much lower than the typical average at this point in the year. Of the €48 billion thus far, over half has come from January, with the February through April average only €7.5 billion. While issuers may have slightly higher cash balances on hand than is typical, and the ability to service existing debt is still robust, a continued frigid primary market will pose a major headwind for any issuers in need of new funding.

Chart 3

Financing conditions on loans to enterprises (as measured by the ECB's Euro Area Bank Lending Survey) also tightened in the first quarter and are likely to tighten even more than in the height of the pandemic in mid-2020 (see chart 4). In the quarter, lending conditions tightened in response to increased risks and decreased risk tolerance among senior loan officers. For the current quarter, loan officers expect further tightening in response to continued economic uncertainties as well as ahead of tighter monetary policy later in the year. Loan officers expressed concerns over the impact of supply chain disruptions, high energy prices, and corporate exposures to Russia, Ukraine, and Belarus. This may contrast with our analytical team's base case, which expects exposure of European banks to ruble-based assets to be manageable, in large part to the shrinking financial links between European lenders and Russia, Ukraine, and Belarus since Russia's annexation of Crimea in 2014.

Chart 4

Market pricing for lower-rated borrowers has started widening as risks mount (see chart 5). Spreads on speculative-grade bonds and leveraged loans have risen in recent months and could rise more as inflation continues to increase, potentially forcing central banks to tighten monetary policies further, or earlier, than previously communicated. Through April 30, the speculative-grade bond spread reached 454 basis points (bps), up from 331 bps at the end of 2021. The spread had reached over 500 bps in early March before retreating somewhat after Ukraine declared it would not pursue NATO membership.

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% is above what this historical trend would suggest.

Chart 5

Market Pricing Appears Largely Appropriate

Using a framework based on broad measures of financial market sentiment, economic activity, and liquidity, we estimate that at the end of March, the speculative-grade bond spread in Europe was about 15 bps above our estimate of 385 bps (see chart 6).

The small gap between the actual and estimated spread implies that despite numerous headwinds and current volatility, fixed-income investors in Europe are generally pricing in risk appropriately, for now.

Chart 6

Some Rate Sensitivity Among The Lowest-Rated Debt

With a still very low Euribor rate, most speculative-grade borrowers with floating-rate debt still have some room to maneuver with less interest-rate sensitivity relative to U.S.-based issuers with outstanding loans priced in Libor. And the amount of outstanding debt coming due through 2023 is still fairly low, at €152 billion. That said, if interest rates rise later this year, as expected, some of the lowest-rated debt may become more difficult to service (see chart 7). What is also important is that many sectors with the most floating-rate debt/loans--particularly those with the most overall debt rated 'B-' and lower--are those most consumer-reliant, led by media and entertainment.

Chart 7

State Of The Consumer Remains Critical

Often central banks will focus on core inflation when considering changes to monetary policy because it's less volatile than the headline measure. However, high food and energy prices--two areas that are seeing rising prices globally and which could be exacerbated further by the nearby military conflict--hurt consumers' ability to support economic activity. For the speculative-grade population, this could be a point of vulnerability since the most represented sectors tend to be those who are consumer-reliant, such as media and entertainment, consumer products, and retail/restaurants, particularly at the 'CCC/C' rating levels (see chart 8).

Chart 8

Point of service sectors have already gone through heightened stress during the worst of the pandemic and resultant lockdowns. With inflation running hotter than it has in decades and no clear sign of the trend abating soon, price pressures will likely curb consumer spending later in the year as reliance on oil and natural gas increase for home heating purposes. Already the military conflict is weighing on consumer sentiment, which by some measures has fallen to its lowest level since the financial crisis (see chart 9).

Chart 9

Positive Credit Momentum Slows, Population Still Vulnerable

In the 12 months ended March 2022, we saw relative stability in credit quality, with net rating actions still deep in positive territory, alongside a slightly negative net bias (see chart 10). Some negative rating actions were seen by Russian companies incorporated in Europe; however, those ratings have since been withdrawn.

Chart 10

History shows that the rate of downgrades and net negative bias tend to lead the movement in the default rate by several quarters. This could portend a fairly low default rate for the next couple of quarters, which could give way to existing stressors late in the year or early 2023.

That said, recent improvements in credit quality have not been to the same extent as the declines during 2020. This still leaves much of the speculative-grade population more vulnerable than is historically typical (see chart 11). A temporary uptick in the number of 'CCC/C' rated issuers was seen in March as a result of downgrades among some Russian issuers incorporated in other European countries. But with those ratings now withdrawn, the ratio of 'B-' and lower issuers has returned to roughly the same level as before these downgrades, a still-high 29% at the end of April, compared with just under 22% at the end of 2019.

Chart 11

How We Determine Our European Default Rate Forecast

Our European default rate forecast is based on current observations and expectations of the likely path of the European economy and financial markets.

This study covers 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

• Global Macro Update: Growth Forecasts Lowered On Longer Russia-Ukraine Conflict And Rising Inflation, May 17, 2022
• Risky Credits: The Number Of European 'CCC' Issuers Rises, While Liquidity And Leverage Indicators Point To Potential Future Stress, May 11, 2022
• The Russia-Ukraine Conflict: European Banks Can Manage The Economic Spillovers, For Now, April 21, 2022
• Credit Conditions Europe Q2 2022: Seismic Shocks, Security & Supply, March 29, 2022