Chart 1

Rising Costs, Rising Rates

So far, interest rates have increased across the board--from Treasuries to investment-grade and speculative-grade corporate debt. This is perhaps more indicative of a normal shift away from fixed rate debt amid expectations for rising rates than a flight to safety. However, in recent weeks Treasury yields have started to stabilize while speculative-grade yields continue to rise, causing spreads to widen. However, moving too haphazardly risks harming consumer spending, which is key to sectors like 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).

Chart 2

Through 2020-2021, the relative cost of debt was manageable despite increased levels of borrowing because interest rates hit new all-time lows for speculative-grade bonds and loans. But the age of "easiest money" is likely past. Previously, the total cost of debt for nonfinancial corporates and total profits have both gone through cycles, while increasing over time (see chart 3). At the end of 2021, corporate profits were riding high while interest rates were on the cusp of rising quickly in only the next three months. With inflation still running hot and interest rates showing no sign of declining soon, profit margins may be challenged later this year.

Chart 3

With interest rates rising, floating-rate debt will become more expensive to service. With that in mind, fully 65% of the outstanding speculative-grade debt rated 'B-' or lower in the U.S. is floating rate debt, largely referenced in Libor, which, as previously shown, has risen quickly in 2022 (see chart 4). Two sectors in particular: high technology and consumer products, have roughly 85% of their existing 'B-' and lower debt in loans. Meanwhile, media and entertainment has the largest amount of outstanding debt at this rating level, making the economic health of the consumer an important bellwether for the weakest issuers going forward.

Chart 4

Volatility Pushes Up Borrowing Costs And Slows Primary Markets

After strong leveraged loan issuance led to a hot start this year, speculative-grade debt issuance stalled in February as sentiment shifted amid the Russia-Ukraine conflict. Total debt issuance has been weak in each of the past three months (see chart 5).

Speculative-grade bond issuance slowed when the year began as rising rates reduced demand for fixed-rated debt. Since February, even fewer speculative-grade bonds have been issued, and at increasingly restrictive levels. Meanwhile, leveraged loan issuance has steadily picked back up with more moderate issuance in April. As rates quickly rise this year, capital markets access for weaker-rated speculative-grade issuers may become more restricted.

Chart 5

The relative risk of holding corporate bonds can be a major contributor to future 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 future defaults based on a lead time of roughly one year (see chart 6). At 346 basis points (bps), the speculative-grade bond spread implies a 1.9% default rate by March 2023.

Chart 6

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 future defaults across all points in the credit and economic cycles (see chart 7).

Chart 7

The distress ratio has been 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 like the speculative-grade spread, but with a nine-month lead time instead of one year. The 2.4% distress ratio in April corresponded to a roughly 1.8% default rate for December 2022.

Some Spread Widening Should Be 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 March the speculative-grade bond spread in the U.S. was about 143 bps below the implied level (see chart 8). We expect modest widening in the spread as monetary policy tightens in 2022 and the economy decelerates toward trend growth.

Chart 8

Credit conditions have quickly tightened on increasingly hawkish forward guidance from the Federal Reserve. S&P Global economists now see 50 bps rate hikes on the table at each of the next two Federal Open Market Committee meetings and cannot rule out a 75-100 bps hike at some point this year.

Amid the quickly changing market, secondary markets have been volatile. The speculative-grade spread widened about 57 bps in February since the Russia-Ukraine conflict before finishing the quarter tighter than its level at beginning of the year. Since the first quarter ended, the speculative-grade spread has widened again, this time about 73 bps to its current level of 419 bps--the widest level of the year.

Table 1

Positive Credit Momentum Slows For A Still Vulnerable Population

Speculative-grade upgrades have slowed after peaking in the second quarter of 2021. Positive rating actions early in the recovery were frequently tied to improved liquidity. As growth accelerated last year, credit quality improved for many issuers on reduced leverage as cash flow improved. The outlook was broadly favorable entering 2022, but the buildup of risks this year has tempered that somewhat. As growth decelerates and financial conditions tighten, we expect positive rating actions will continue to trend lower (see chart 9). Net rating actions are upgrades minus downgrades as a percentage of the issuer-base on a 12-month trailing basis and does not include movement to default. Net bias is the positive rating bias minus the negative rating bias, based on current outlook and CreditWatch placements.

Chart 9

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 quarter; which could give way to existing stressors late in the year or early 2023.

However, 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 10). Though showing a decline over the last year or so, the proportion of speculative-grade issuers with a 'B-' or lower rating has slowed its recent decent and these issuers could be more vulnerable to default if current challenges persist or grow.

Chart 10

There are several sectors that have weak speculative-grade rating distributions, but four currently stand out.

Consumer/service and leisure time/media account for 44% of speculative-grade issuers with a negative bias and have high proportions of issuers rated 'B-' or lower. Issuers in these sectors will be impacted if consumer and advertising budgets become constrained.

Aerospace/automotive/capital goods/metal sector also has a high proportion of issuers rated 'B-' or lower, and accounts for 16% of speculative-grade issuers with a negative bias. Capital goods and automotive issuers account for most of these, and issuers in these industries will be impacted by the persistence of inflationary pressure and supply-chain disruptions.

Health care/chemicals has the second highest proportion of 'B-' issuers and accounts for 12% of speculative-grade issuers with a negative bias. Issuers in the sector will be impacted by the persistence of labor and supply-chain challenges.

These sectors combined account for nearly 75% of speculative-grade issuers with a negative bias and over 66% of 'B-' or lower rated issuers.

Chart 11

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 1.5% in March 2023 (29 defaults in the trailing 12 months) in our optimistic scenario and 6% (115 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
• The U.S. Distress Ratio Remains Low But May Rise As Financing Costs Increase, Feb. 7, 2022
• Economic Outlook U.S. Q1 2022: Cruising At A Lower Altitude, Nov. 29, 2021
• The Economic Impact Of Default Is Falling As Selective Defaults Rise, Sept. 16, 2021
• 2020 Annual Global Corporate Default Study And Rating Transitions, April 7, 2021