Chart 1

S&P Global Ratings Credit Research & Insights expects the U.S. trailing-12-month speculative-grade corporate default rate to reach 3.75% by September 2023, from 1.6% in September 2022 (see chart 1).   This base-case scenario is more than double the current default rate, but it is still lower than the long-term average of 4.1%. Since our last update, the U.S. saw GDP increase after two quarters of declines. That said, we think that this was more of a last hurrah for the U.S. economy, rather than a reversal of fortune. Our economists have updated their forecasts to reflect a recession in 2023. But many companies are well-placed to withstand a downturn, having built up large cash reserves since 2020 and refinanced existing debt on very favorable terms. The default rate is currently low, but much will depend on the length, breadth, and depth of a recession should one occur, and if the Fed will continue to raise rates through a recession if it feels inflation is still too high. Rating trends have started to indicate we're now past peak credit quality in the post-COVID-19 period.

In our optimistic scenario, we forecast the default rate could hit 1.75%.   In this scenario, inflation will peak in the next few months (if it hasn't already), with the Fed opting for fewer, or smaller, rate hikes. A recession is avoided, and energy prices decline, allowing consumers to avoid any major pullback in spending, keeping companies afloat. Wages and other input costs would start to decline or slow, and borrowing costs would also fall, opening primary markets for a resumption of normal lending activity after this year's relative drought.

In our pessimistic scenario, we forecast the default rate could rise to 6%.   For now, we assume the upcoming recession will be relatively short-lived and not especially deep in terms of economic contraction. That said, if a more widespread, deeper, or longer downturn were to occur, defaults could rise materially from their current low levels. This could be further exacerbated if inflation were to remain high, forcing the Fed to keep rates elevated or continue raising them longer than expected. The current pace of widening yields in secondary markets would continue, while consumption would contract, forcing businesses to dig into their cash holdings to ride out a deeper recession.

Recession Odds Are Rising, But Perhaps With A Limited Impact

Consumer sentiment in the third quarter remained dour given increased inflation expectations and further expected wealth deterioration (via continued falling equity prices). That said, the October CPI (Consumer Price Index) reading did come in lower than expected, with markets reacting favorably since. Key to the path of the U.S. economy are both inflation and consumer resilience. The unemployment rate remains relatively low, at 3.7%, and nominal wages have been increasing. But real wages have been falling to their lowest levels since the financial crisis. This complicated backdrop will become more important for our default projections because of the weakest-rated issuers (those in the 'CCC'/'C' category), over 50% are from heavily consumer-reliant sectors (see chart 2).

Chart 2

Despite increasing headwinds, credit markets appear relatively positive--when looking at relative risk pricing via corporate bond spreads (see chart 3). The overall speculative-grade spread has seen some movement this year, but it's still within levels typical of a benign macro environment. Meanwhile, the 10-year/three-month Treasury yield curve has inverted--a strong indicator of a recession ahead. This is not to say markets are turning a blind eye to risk: The 'CCC'/'C' spread has widened considerably this year, starting 2022 at 634 basis points (bps) and reaching 1,016 bps as of Nov. 9. This represents a widening of 60%, compared with only a 17% increase for the overall speculative-grade spread. Additionally, over the last 10 years or so, the largest rating category among outstanding bonds has shifted from 'B' to 'BB', indicating the overall speculative-grade bond spread may reflect relatively less risk than in the past.

Chart 3

That said, benign trends in secondary markets have not yet spilled over into primary markets. Issuance remains weak, and it is too early to expect near-term relief from the Fed. Policy rates are widely expected to continue increasing for the next six months, at least.

Volatility Pushes Up Borrowing Costs And Slows Primary Markets

Speculative-grade debt issuance remains constrained by a high cost of capital across the speculative-grade rating spectrum (see chart 4). Leveraged loan issuance plummeted to $78.1 billion and speculative-grade bond issuance to $17.3 billion in the third quarter--the lowest levels of third-quarter issuance for each since 2011 and 2008, respectively. Since September, issuance has flatlined. While primary markets will remain challenging for speculative-grade issuers, for now, refinancing risk generally appears modest.

Chart 4

The relative risk of holding corporate bonds can be a major contributor to future defaults because of the 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 roughly one-year lead time (see chart 5). At 481 bps, the speculative-grade bond spread implied around a 2.9% default rate by September 2023.

Chart 5

While the speculative-grade spread is a good indicator of broad market stress, defaults are generally rare during most points in the economic cycle outside of downturns. However, 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 credit and economic cycles (see chart 6).

Chart 6

The distress ratio 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 similar to the speculative-grade spread, but with a nine-month lead time as opposed to one year. The 7.6% distress ratio in October then implies about a 2.7% default rate for July 2023.

Some Spread Widening Is Expected In 2022 As Conditions Deteriorate

Using the Volatility Index (VIX), the ISM Purchasing Managers Index, and components of the money supply, we estimate that at the end of September the speculative-grade bond spread in the U.S. was about 320 bps below the implied level (see chart 7). We expect widening in the spread to resume in the months ahead as headwinds increasingly pressure credit quality and particularly as the expected recession unfolds.

Chart 7

Credit conditions will continue to tighten as the Federal Reserve clamps down further on market liquidity. Even if spreads tighten, credit conditions will likely be more restrictive for speculative-grade issuers in the coming months. While market participants had been anticipating further policy tightening from the Federal Reserve, additional rate hike bets were spurred recently by hawkish comments from Federal Reserve Chair Jerome Powell after the November Federal Open Market Committee meeting. Based on fed funds futures, market participants are now betting on at least a 50-basis-point rate hike in December, and they see the Federal Reserve reaching a terminal rate of 5.0-5.25% by March 2023. As a result, borrowing costs for speculative-grade issuers could rise another 125 bps--or more--in the next few months.

Mixed signals are setting the stage for tough conditions for investors in 2023. On one hand, we see that:

• Most corporate issuers started the year with ample liquidity following strong issuance and growth in 2021,
• Consumers have continued to spend,
• The unemployment rate remains historically low,
• Aggregate corporate earnings have been solid--and are expected to remain solid, and
• Secondary markets currently show muted signs of distress.

On the other hand, rating indicators show some very early signs of credit deterioration, access to capital is restrictive, a recession in 2023 is all but a foregone conclusion, and guidance from the Federal Reserve suggests that monetary policy will remain tight for as long as it takes to bring inflation back toward its 2% target. This points to macroeconomic conditions as an important driver for speculative-grade credit quality in 2023. Next year, financial conditions will be very tight, and, at the same time, economic growth is expected to slow. How long financial conditions remain tight amid sluggish growth will be important to monitor.

Downgrades Could Pick Up As Headwinds Persist

Speculative-grade upgrades continue to slow, and downgrades are rising. However, the negative rating momentum may be slow to pick up since many issuers benefited from cushions built up since the 2020 recession. While speculative-grade credit quality could remain somewhat resilient in a shallow recession, the buildup of 'B-' rated issuers could contribute to sharper deterioration if headwinds--including low growth, inflation, supply-chain tightness, and higher debt service--either worsen or persist next year (see chart 8).

Chart 8

For the third quarter, just three sectors had a positive net bias, but only four sectors show negative net rating actions (see chart 9). With net biases worsening in 77% of sectors, this may signal a turning point for speculative-grade credit, as we are continuing to see increased instances of credit deterioration.

Chart 9

Credit Migration Risk By Sector

Five sectors stand out in the current environment. Combined, these five sectors account for nearly 76% of speculative-grade issuers with a negative bias and 85% of weakest links.

Consumer/service:  Some consumer/service issuers are reporting weak operating results. Inflation, supply-chain tightness, and challenging macroeconomic conditions are weighing on issuer credit quality.

Leisure:  Weaker macroeconomic conditions are expected to strain credit quality for some leisure issuers--especially those exposed to advertising spending--and we are already seeing evidence of a slowdown. There is divergence in the sector though, with credit quality for some issuers underpinned by improved fundamentals amid continued normalization in social activity.

Aerospace/auto/capital goods/metal:  Within the aerospace/auto/capital goods/metal sector, high inflation and supply-chain disruptions are affecting capital goods and auto issuers.

High technology and health care:  Rising interest expense is straining cash flows, specifically for issuers that rely on the leveraged loan market for capital. We are already seeing evidence of this for some highly leveraged issuers in high technology and health care--and issuers in these sectors are also contending with difficult macroeconomic conditions more broadly.

Chart 10

Chart 11

Despite overall stability in the U.S. speculative-grade population, a higher share is more vulnerable than is historically typical (see chart 12). The proportion of speculative-grade issuers with a 'B-' or lower rating has declined over the last year or so, but that descent has slowed recently, and these issuers could be more vulnerable to default if current challenges persist or grow.

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 September 2023 (32 defaults in the trailing 12 months) in our optimistic scenario and 6% (111 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

• Weakest Links Rise, Signaling Defaults Ahead, Nov. 15, 2022
• 10-Year/3-Month Yield Curve The Latest Domino To Fall, Nov. 1, 2022
• Business Cycle Barometer: Worsening Near-Term Growth Prospects, Oct. 24, 2022
• 2021 Annual Global Corporate Default And Rating Transition Study, April 13, 2022