Base Case Calls For More Defaults, But Not A "Spike"

Baseline scenario

S&P Global Ratings Credit Research & Insights expects the European trailing-12-month speculative-grade corporate default rate to rise to 3.25% by December 2023 from 2.2% as of December 2022 (see chart 1). Economic growth is expected to stall for the eurozone and produce a recession in the U.K. in our economists' base case this year. Corporate profits are already showing signs of cooling, and interest rates remain high with the European Central Bank (ECB) now expected to take the deposit rate up to 3%.

Offering some relief to the picture, energy costs have come down from their late 2022 highs (but still remain historically elevated), easing near-term economic disruptions and helping to give a lift to consumer confidence. Though early days in the long path back to normal, headline inflation has been falling consistently in recent months for consumers and producers alike (see chart 2). This has resulted in some recent declines in corporate bond yields and spreads as bond investors have reacted to this reduction in prices with optimism. We believe this combination of factors will result in a rise in defaults this year, but not a large increase.

Chart 1

Chart 2

Optimistic scenario: We forecast the default rate could fall to 1.5%

In a best-case scenario, we feel defaults could decline slightly to about 1.5% through December--roughly around the level in 2021. Markets have turned more optimistic in the last three months, with bond spreads tightening and high-yield issuance showing signs of life recently. Headline inflation readings at both the consumer and producer level have been coming down consistently, and energy prices have fallen markedly as the governments moved quickly to stockpile reserves during what has thus far been a mild winter. We expect the ECB and Bank of England (BOE) to continue raising rates, but market yields have nonetheless come in on the fixed side in recent weeks after this more positive economic data gets reported. Upcoming maturities--particularly those for the weakest ratings ('CCC+' and lower)--are minimal (€14.7 billion through 2024).

Pessimistic scenario: We forecast the default rate could rise to 5.5%

Although there has been more positive sentiment building recently, the list of potential headwinds in Europe remain the same: volatile energy prices, the ongoing Russia-Ukraine conflict, sticky inflation, higher interest rates, and deeper recessions could stress many of the weaker issuers at a time when profits appear to already be slowing. Another unknown is how the lifting of China's zero-COVID-19 policies may affect global markets, in particular supply chains and the potential to "export" inflation. Some effect on global prices is likely, but the ultimate impact is unknown. Similarly, if more outbreaks occur within China, global supply chain volatility could increase. In either outcome, stress on corporate cash flow would increase.

Issuance Ends 2022 Muted, And So Are Upcoming Maturities

Market volatility last year--driven primarily by rapid interest rate hikes--kept issuers and investors alike on the sidelines. Combined leveraged loan and speculative-grade bond issuance fell off markedly versus prior years, posting an annual total of only €118 billion through December (see chart 3). This is 63% below 2021's record pace and much lower than the roughly €232 billion average annual total since 2018. Of the €118 billion, nearly 39% came in the first quarter.

While issuers may have slightly higher cash balances on hand than is typical, and most debt is maturing well past 2023, the ability to service existing debt will pose an increasing challenge if rates continue to rise and revenues start to flag, the latter being more likely. In such a scenario, a continued frigid primary market would pose a major obstacle to any speculative-grade issuers in urgent need of new funding. That said, 2023 is off to a more optimistic start in the high-yield space, with €11.6 billion hitting the market--the highest monthly total since January 2022. Though positive, it is still very early in the year to say markets have unquestionably turned the corner.

Chart 3

However, even if markets don't completely shake their 2022 hesitation this year, upcoming maturities through 2024 remain manageable (see chart 4). Through 2024, we estimate €177 billion in total speculative-grade debt will be coming due, with €14.7 billion of that attributable to the 'CCC/C' category. Of the €71.4 billion total due this year, a majority is from the 'BB' category, reflecting a lower likelihood of default. That said, 'B' rated maturities will pick up in 2024, and the aggregate total will expand at a faster pace to €174 billion in 2025.

Chart 4

Loan Lending Conditions Tighten, While Bond Spreads Loosen

Financing conditions for loans to enterprises (as measured by the ECB's euro area bank lending survey) tightened even further in the fourth quarter and are expected to continue to do so this quarter--even more than during the height of the pandemic in mid-2020 (see chart 5). The fourth quarter's tightening was in response to the deteriorating economic outlook, industry-specific risks, and decreased risk tolerance among senior loan officers. For the first quarter, loan officers expect significantly stronger net tightening in response to economic uncertainties as well as further monetary policy tightening. Many banks have been building buffers in preparation for more loan losses recently, and similar tightening ahead of an expected recession has been happening among U.S. banks. In both regions, demand for loans has also trailed off at the end of 2022.

Chart 5

In contrast to tightening conditions on corporate loans, bond markets have recently been reflecting a relative loosening of conditions. Through Dec. 31, the speculative-grade bond spread reached 498 basis points (bps), up from 331 bps at the end of 2021 (see chart 6). The spread has been exceptionally volatile since January 2022, more recently widening from mid-August through the first half of October, likely in response to the threat that rapidly rising gas prices pose for the European economy. But they've fallen back since, in line with declining gas prices, and most recently, down to 441 bps at the end of January, to roughly the same level at the end of February 2022 shortly after the start of the Russia-Ukraine conflict.

The relative risk of holding corporate debt can be a major indicator of future defaults because companies face pressure if they are unable to refinance maturing debt or service existing debt. In broad terms, speculative-grade spreads have been good indicators of future defaults based on a roughly one-year lead time. At current spreads, our baseline default rate forecast of 3.25% is roughly in line with or slightly above what the historical trend would suggest. One caveat in the current environment is that low spreads are potentially masking the rising cost of debt, as benchmark rates have been increasing quickly in the last 12 months.

Chart 6

Using a framework based on broad measures of financial market sentiment, economic activity, and liquidity, we estimate that at the end of December, the speculative-grade bond spread in Europe was about 95 bps below our estimate of 593 bps (see chart 7). The gap between the actual and estimated spread implies that bond markets may be overshooting somewhat in their recent optimistic stance.

Chart 7

Some Rate Sensitivity Among The Lowest-Rated Debt

Considering this possible divergence between bond and loan market sentiment, it is worth noting that much of the lower-rated debt ('B-' and below) in Europe is in the form of floating-rate loans, whose benchmark interest rates are rising in both Europe and the U.S. as central bank rates continue to rise (see chart 8). EURIBOR remains well below LIBOR but is rising at a very fast pace, and many loans have very low floors--sometimes zero. If this trajectory continues, higher rates will start cutting into profit margins for these issuers, giving them less room to maneuver, particularly in the event of an economic slowdown or recession.

Chart 8

The overall near-term maturity profile of European speculative-grade issuers is fairly light and should be largely manageable this year, limiting the possible sticker-shock that could be felt by firms rolling over their fixed-rate debt at current market rates. But the outstanding proportion of floating-rate debt among the lowest rating levels presents an ongoing challenge via increasing debt servicing costs. As of the start of the year, there was €238 billion in outstanding debt rated 'B-' or lower, with 60% of that carrying floating interest rates (see chart 9). Perhaps more pointedly, the sectors most reliant on consumer spending clearly lead the way on the floating-rate total: consumer products, media and entertainment, and retail/restaurants.

Chart 9

Consumer Strength Remains Key For Weaker Credits

One key point we've been watching is the ability of consumers to continue propping up demand amid high energy prices, rising inflation, and slowing growth. Their ability to do so will undoubtedly be challenged later this year if our economists' base cases for higher unemployment materialize. Among our weakest rated issuers, over half of the 'CCC/C' population is from consumer-reliant sectors and capital goods (see chart 10). Our 'CCC/C' default rate reached nearly 50% during the peak of the pandemic in late 2020, implying the potential for very high default risk should a worst-case scenario play out.

Chart 10

Credit Momentum Swings Negative But Still Far From Prior Downturns

In the 12 months ended December 2022, speculative-grade credit quality was relatively stable, with net rating actions still in positive territory, but with a negative net bias implying more downgrades expected (see chart 11). This was little changed from the rating action trends over the prior 12 months. The speculative-grade net rating bias (the positive bias minus the negative bias) declined to -6.8%, following an all-time high of -2.2% at the end of June 2022.

History shows that the rate of downgrades and net negative bias tend to lead the movement in the default rate by several quarters. Current downgrade rates and bias reflect a likely turning point in credit momentum, which should lead to more defaults ahead, but this deterioration is still very mild.

Recent improvements in credit quality have not been enough to make up for the declines during 2020, leaving speculative-grade issuers still much more vulnerable than historically (see chart 12). And while our base-case assumption is that the eurozone will exhibit flat growth in 2023, S&P Global Ratings economists' odds of a full-fledged recession in 2023 have increased to 70% (up from 47% last quarter). Due to this increasing likelihood, we expect economic growth to slow meaningfully, and perhaps even contract, which could strain many of the weakest borrowers.

Chart 12

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 report covers financial and nonfinancial speculative-grade corporate issuers. The scope and approach are consistent with those of our default and rating transition studies. In this report, our default rate projection incorporates inputs from S&P Global Ratings economists that also 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 positively correlate 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.

This report covers issuers incorporated in the 31 countries of the European Economic Area, Switzerland, and 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.

Two defaults in the second quarter, from Petropavlovsk PLC and EuroChem Group AG, were captured as defaults from the U.K. and Switzerland, respectively, due to the locations of incorporation and corporate headquarters. The ratings on these issuers were subsequently withdrawn as of April 15 because these were considered to be entities with substantial presences in Russia. We do not include Russia in our definition of Europe. If we were to remove these issuers from the count of defaults, the 12-month-trailing default rate ended December 2022 would have been approximately 1.9%, down from the 2.2% reported throughout this report. Adjustments of similar magnitude would appear for default rates ended in April and May 2022, as well as for future rates.

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