S&P Global Ratings Credit Research & Insights expects the U.S. trailing-12-month speculative-grade corporate default rate to reach 4.5% by June 2024, from 3.2% in June 2023 (see chart 1).   In our base case, we expect defaults to continue rising as corporates grapple with higher interest rates and slower growth ahead. Rising rates are eroding profitability, and second-quarter earnings estimates forecast declining profits relative to a year ago, in aggregate.

Downgrades and defaults from falling cash flow and rising debt costs have increased across many sectors, and much of the debt rated 'B-' or lower is among floating-rate loans. Although headline inflation continues to fall, core inflation has been stickier, keeping central banks on a hiking schedule. A potential confluence of rising rates, elevated costs, and slowing growth could push the default rate higher still.

Chart 1

In our optimistic scenario, we forecast the default rate could fall to 2%.   In this scenario, economic resilience would continue alongside falling inflation, resulting in a "soft landing" for the economy and financial markets. This would give the Federal Reserve space to lower rates.

In turn, investors would return to chasing yield among speculative-grade issuers, providing relief for many weaker issuers in primary markets to face 2025 maturities. This scenario would depend on interest rates falling sooner than markets and the Fed expect.

In our pessimistic scenario, we forecast the default rate could rise to 6.5%.   In this scenario, the U.S. would enter a recession, slowing revenues further. If this is accompanied by sticky or higher core inflation, this situation could be made worse for borrowers if the Fed keeps rates elevated or engages in further increases.

The weakest borrowers are already facing cash flow challenges. In this scenario, these challenges will increase and infect more borrowers. This is of particular concern for the many issuers rated 'B-' and below, which are largely financed via floating-rate leveraged loans. Many of these sectors also depend on consumer spending, which we believe could come under stress.

The Rising Costs Of Rising Rates

Economic growth continues to surprise to the upside, with another quarter of above-2% economic growth in the second quarter. As of this writing, preliminary GDP growth estimates for the third quarter of 2023 are around 4.1% (per the Atlanta Fed's GDP Now estimate).

But the cost of a strong economy has been 18 months of quickly rising interest rates to combat inflation. For the five years leading up to 2022, issuers had been able to come to market at coupon rates well below those on their existing debt. But since the first quarter of last year, the opposite has been true. Average interest rates on new 'B' rated bonds came in at 9% in the second quarter, compared to 7.1% on bonds that, at issuance, were slated to mature in the second quarter (see chart 2).

When looking at upcoming bond maturities, 'B' debt jumps to $13.8 billion in the second quarter of 2025, from less than half of that in the first quarter. Firms typically start to address upcoming maturities within 6-18 months of the principal due date.

It remains to be seen if issuers decide to get ahead of these maturities at current rates or wait, on the assumption rate cuts will become more likely in 2024. While most feel this is the most likely path for interest rates, it is far from guaranteed.

Chart 2

Defaults have been rising this year, but only to about 3.2%. This is low by historical standards, but about double the pace of defaults through as recently as November 2022. More broadly--beyond the rated population of corporate issuers--businesses are generally weathering higher rates well (see chart 3). The delinquency rate on business loans in the U.S. was just below 1% through the first quarter--still near the record-low pace seen from late 2014-2015.

Conversely, consumers are starting to show some wear and tear from over a year of rising rates. The delinquency rate for consumer loans rose for the sixth straight quarter in first-quarter 2023, to 2.23%--its highest level since the pandemic. Meanwhile, homebuyers are facing the highest mortgage rates in nearly 20 years. Some banks are reporting rising rates of hardship loans being taken out against 401(k) balances, and subprime auto loan delinquencies also appear to be trending upward.

These considerations offset generally positive headline labor market figures, such as low unemployment rates and rising nominal wages. However, on some level, consumers have not been as strong as suspected. This is an important consideration for future defaults, as many of the weakest borrowers hail from consumer-reliant sectors such as media and entertainment, consumer products, and retail/restaurants.

Chart 3

Banks And Markets Have Different Risk Assessments

While perfect agreement on potential economic or financial outcomes is rare, banks and bond markets have historically tended to agree on current and implied credit risk. Now, however, bond and leveraged loan markets appear much more optimistic than bank loan lending officers (see chart 4).

This divergence began during the pandemic in 2020, with the Fed's senior loan officer survey showing much higher levels of net tightening on new business loan standards relative to bond market pricing. The Fed survey of second-quarter conditions rose to 50.8% net tightening and has been accelerating in recent quarters. Meanwhile, bond and loan spreads have been falling since the third quarter of 2022. This divergence seems largely rooted in banks being less optimistic about the future course of the economy than public markets.

Chart 4

Credit spreads 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 roughly one-year lead (see chart 5). At 356 basis points (bps) in June, the speculative-grade bond spread implies a 1.95% default rate by June 2024.

Chart 5

The speculative-grade spread is a good indicator of broad market stress, but the corporate distress ratio is a more targeted indicator of future defaults across credit and economic cycles, especially during periods with more accommodative funding. The distress ratio shows a similar relationship to the speculative-grade spread, but with a nine-month lead. The 7.3% distress ratio in July would correspond to a 2.6% default rate for April 2024 (see chart 6).

Chart 6

Bond Spreads May Be Too Optimistic

Using the CBOE Volatility Index (VIX), the ISM Purchasing Managers' Index, and components of the money supply, we estimate that at the end of June, the speculative-grade bond spread in the U.S. was about 215 bps below the implied level (see chart 7).

Market volatility is still relatively low, particularly compared with 2022, which supports a lower spread estimate. On the other hand, economic activity continues to slow, particularly in the manufacturing sector, which supports a wider estimated spread. The net effect seems to indicate that current spreads are historically optimistic given similar past circumstances.

Chart 7

We Expect Credit Conditions To Remain Stressed Over The Next 12 Months

Market signals may appear rather bullish recently, but many other credit and economic indicators have been deteriorating, if slowly (see table 1). Bank lending conditions continue to tighten, the yield curve continues to deepen (having already inverted), corporate profits declined last quarter, and the ratio of downgrades and weakest links remain elevated. (Weakest links are issuers rated 'B-' or lower by S&P Global Ratings with negative outlooks or ratings on CreditWatch with negative implications.)

We expect credit risk to build over the next 12 months. Speculative-grade maturities will grow in 2024, and are notably higher in 2025. Credit conditions will remain restrictive as refinancing risk climbs entering 2024.

Speculative-grade yields have room to rise further, particularly as Treasury yields are rising to new highs for the year. Meanwhile, markets don't expect the Fed to cut rates until around next March, implying little relief for borrowers in the near term.

Table 1

Negative Rating Pressure Is Building At The Lower Rating Levels

Negative rating actions have remained tepid, but we expect them to increase. Speculative-grade credit quality has proven resilient thus far, but the buildup of 'B-' rated issuers, many with significant floating-rate debt, adds to downside risk. This could contribute to a sharper deterioration in our speculative-grade ratings if rates remain high for an extended period (see chart 8).

Chart 8

In the second quarter, just two sectors had a positive net bias, and all but three sectors had negative net rating actions (see chart 9). (We define net bias as the share of issuers with ratings that have positive bias, meaning those with positive outlooks or ratings on CreditWatch positive, minus the share of ratings that have negative bias.)

Overall negative credit trends would likely have been deeper, in aggregate, had it not been for the positive experience of the energy and natural resources sector, which, given its size, is influencing the overall trend.

Chart 9

Four sectors combined account for over 56% of speculative-grade issuers with a negative bias and 58% of weakest links.

The consumer/service sector leads in terms of weakest links through June 30, 2023. The state of the consumer is the biggest wild card now. While inflation has tempered, the Fed may raise rates further to cool the economy, leading to higher unemployment. The sector may also face strained cash flow given higher for longer interest rates.

Media and entertainment had the second highest number of potential downgrades through the second quarter. (Potential downgrades are issuers rated by S&P Global Ratings with a negative outlook or a rating on CreditWatch negative.) Despite resilient consumer spending in the U.S., advertisers have been hesitant to spend given macroeconomic uncertainty and the potential for a pullback on consumer spending.

Higher for longer interest rates could deplete consumer savings, weakening discretionary spending, such as streaming subscriptions. The ongoing writers strike could also damage the already fragile media and entertainment market, with less new content hurting the TV and film, streaming, and advertising subsectors. That said, there is divergence in the sector, with credit quality for some issuers underpinned by improved fundamentals amid the continued normalization of social activities and strong spending on services.

The health care sector has also exhibited weakness through the first half, adding 30 issuers to the U.S. weakest link tally. Elevated labor and material costs, coupled with staff shortages, are weighing on margins and cash flow. The sector is also more vulnerable to cash flow disruptions amid higher interest rates given its larger share of weaker-rated issuers (those rated 'B-' and below) with floating rate debt.

The high technology sector's performance has historically been highly correlated with global growth rates. While the U.S. economy has been remarkably resilient to higher rates so far, their full impact on the U.S. economy has yet to be seen, considering the lagged effects of interest rate changes. Higher interest expenses have been absorbing free operating cash flow in the tech space. If demand weakens, we expect ratings pressure to intensify.

Credit Migration Risk By Sector

Chart 10

Chart 11

As downgrades of speculative-grade issuers have increased since the pandemic, the share of issuers rated 'CCC' to 'C' has grown (see chart 11). In fact, the downgrade rate from the 'B' category has risen sharply, to 7.6% in the 12 months ended June 2023, from a low of 1.5% at the end of 2021. These lowest-rated issuers have historically had a much higher default rate and we expect them to see greater stress over the next few quarters.

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 2% in June 2024 (33 defaults in the trailing 12 months) in our optimistic scenario and 6.5% (109 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

• This Month In Credit: Glimmers Of Sunlight (July 2023), July 28, 2023
• Economic Research: The Fed's Hike Trajectory Walks A Tightrope Between Disinflation, Growth, July 27, 2023
• Economic Outlook U.S. Q3 2023: A Sticky Slowdown Means Higher For Longer, June 26, 2023
• 2022 Annual Global Corporate Default And Rating Transition Study, April 25, 2023