Confluence Of Pressures Raises Our Base Case

Baseline: S&P Global Ratings Credit Research & Insights expects the European trailing-12-month speculative-grade corporate default rate to rise to 3.75% by June 2024, from 3% as of June 2023 (see chart 1).   Although there have been positive revisions to our economic projections since the previous forecast in March, the burden of increasing interest rates continues to build. While a recession may well be avoided, growth is still stagnating and cash interest paid has risen roughly 15% from a year ago for European firms during the second quarter.

Producer prices have fallen quickly, offering some reprieve from the high levels of inflation in 2022 for goods producers, but other cost pressures including wages, particularly in the U.K., are still increasing. Firms have some room to cut discretionary costs further by reducing capital expenditures and dividends, slow hiring, and continued pullback in mergers and acquisitions, but these options are either unavailable, or would have less room for meaningful impact for many within the historically large group of lower-rated borrowers.

Chart 1

Optimistic scenario: We forecast the default rate could fall to 1.75%.  In a best-case scenario, we think the default rate could decline slightly to about 1.75% through June 2024. Economic resilience would need to continue and lending conditions would improve, and current market pricing seems to reflect this expectation. Headline inflation readings at both the consumer and producer levels have been declining consistently, with producer prices now showing falling prices, easing pass-through worries for many, but not all, industries.

If inflation were to fall faster than the current pace – particularly core readings, it could give central banks room to cut rates sooner than our base case assumptions of the second half of 2024. Near-term refinancing needs are small. Although policy rate cuts are not expected in the near-term, more hikes also appear to be limited.

Pessimistic scenario: We forecast the default rate could rise to 5.5%.  In a scenario of slower economic growth or a recession, combined with persistent core inflation, the default rate could rise past 5%. Slowing earnings leave less room to maneuver amid elevated interest rates. Refinancing needs are being addressed, but at a higher cost, and as we get closer into 2024, the large pile of outstanding debt coming due will also need to be addressed. Bond spreads are currently muted, but banks appear to be more cautious in their lending standards given expectations for continued economic uncertainty. The Russia-Ukraine conflict continues to remain a factor for further uncertainty and elevated tail risk, which could lead to more acute stress as winter approaches.

Refinancing risk is currently low, with only €57 billion in speculative-grade debt coming due through 2024. But as this higher-for-longer environment continues, the sticker shock for issuers when they return to primary markets to refinance could be punitive if current market rates persist (see chart 2). Using the 'BB' segment as an example, current coupons on bonds issued in the second quarter of this year were 3.6% higher than those of maturing bonds, on average. About €6 billion of 'BB' bonds is coming due per quarter, through 2024, but this jumps quickly to €15.5 billion at the start of 2025.

Similar, if more volatile trends also happen among 'B' bonds, with current coupons about 1.7% higher than of those on maturing bonds, and if issuers have been downgraded since issuing this debt, they can expect even higher market rates.

Chart 2

Issuance Jumps Slightly Ahead Of Last Year, And Upcoming Maturities Are Minimal

Combined high-yield bond and leveraged loan issuance has remained historically subdued this year, but broke past the 2022 year-to-date totals since May (see chart 3). The pace of bond issuance has been much stronger of the two debt types, and much of the funding has been used to pay down existing debt, helping to reduce refinancing obligations in the near-term. That said, the outlook for any marked improvement in issuance remains subdued. Interest rates are likely to remain high, deterring more growth-oriented drivers of debt issuance, such as mergers or acquisitions.

Chart 3

Even if markets fall off in the second-half, upcoming maturities through 2024 remain very manageable (see chart 4). We estimate €93.7 billion in total speculative-grade debt will come due through 2024, but with only €10.1 billion of that in the 'CCC'/'C' category. Of the €22.6 billion total due for the remainder of this year, a large majority is from the 'BB' category, reflecting a lower likelihood of default because of the inability to refinance upcoming principal payments. But maturing totals jump dramatically in 2025 where €152.7 billion will come due. Depending on the economic and interest rate environments in the next 12 months, these maturities could be challenging.

Chart 4

Lending Conditions Wobble Through Bank Stress

European area banks' pace of net tightening of credit standards were within expectations in the second quarter. The main drivers for banks' tightening in the second quarter were risks related to the economic outlook and firm-specific scenarios. Although expectations are for more decline in net tightening in the third quarter, the survey reading still came in above the series' long-term average, and the cumulative tightening since the start of 2022 has been substantial. Loan demand was particularly weak in the second-quarter; reaching an all-time low of -42% net decline in loan demand by enterprises.

Chart 5

Relative risk pricing of both bonds and loans (through spreads) are reflecting declining risk perceptions on the part of markets (see chart 6). High-yield corporate bond spreads in Europe finished July at 438 basis points (bps), a full 60 bps below where they began the year. Similarly, the spread-to-maturity for the European Leveraged Loan Index (ELLI) has fallen an even larger 100 bps in 2023, ending July at 518 bps. Although rising, defaults remain generally low and the economy has remained resilient with many anticipating a further boost this year because of an anticipated rebound in regional tourism.

The relative risk of holding corporate debt can be a major indicator of future defaults because companies have challenges if they cannot 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 3.75% is above what the historical trend would suggest. However, in contrast to spreads, current yields continue to rise, increasing the all-in costs of debt which issuers must contend with regardless of risk perceptions. While the ELLI spread may have declined 100 bps through July, ELLI yield-to-maturity has increased 50 bps, to 9.06%. That is an understated increase, from the start of 2022, the yield-to-maturity has risen roughly 5%, from 4% at the end of 2021.

Chart 6

Considering broad measures of financial market sentiment, economic activity, and liquidity, we estimate that at the end of June, the speculative-grade bond spread in Europe was about 230 bps below our estimate of 676 bps (see chart 7). The gap between the actual and estimated spread implies that bond markets may be overweight in their optimistic stance.

Chart 7

Floating-Rate Benchmarks Continue To Rise Alongside Policy Rates

Considering the possible divergence between bond and loan market sentiment, 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 climb (see chart 8). EURIBOR, is rising quickly, and if this trajectory continues, higher rates will continue cutting into profit margins for these issuers (especially as interest rate hedges mature), giving them less room to maneuver, particularly during an economic slowdown or recession.

Chart 8

As shown earlier, the near-term maturity profile of European speculative-grade issuers is fairly light and should be manageable this year, limiting the pain for companies rolling over their fixed-rate debt at current market rates. But the proportion of floating-rate loan debt among the lowest rating levels presents an issue in terms of increasing debt servicing costs. At mid-year, outstanding loan debt rated 'B-' or lower totaled €163 billion (see chart 9). The sectors that rely on consumer spending the most, like consumer products, media and entertainment, and retail/restaurants, are at the top of the loan total.

Chart 9

Economic Resilience Remains Key For Weaker Credits

One key point we've been watching is consumers' ability to continue propping up demand amid stubborn inflation and slowing (if resilient) growth. How long that can continue given high core inflation remains to be seen. Among our weakest rated issuers, rated in the 'CCC'/'C' category, more than half are from consumer-reliant sectors and capital goods (see chart 10). The default rate for 'CCC'/'C' rated entities reached nearly 50% during the peak of the pandemic in late 2020 – well above anything reached even during the financial crisis, implying the potential for very high default risk should a worst-case scenario play out. Among issuers rated 'B-' or lower with a negative outlook or CreditWatch, the consumer products and media and entertainment sectors take the lead.

The capital goods and health care sectors are also currently contributing to many weaker issuers. The health care sector has led the default tally so far in 2023, with three. This sector is operating with relatively high leverage at these rating levels, and is the second-largest in terms of loan-based debt rated 'B-' or lower, second only to consumer products. Meanwhile, capital goods could be strained further if China's recent economic slowdown persists or trade tensions with the West increase, which could affect these trade-dependent issuers.

Chart 10

Consumer products.  The consumer products sector led the number of weakest links in Europe through the second quarter (10). Inflation in the region remains sticky, contributing to weaker consumer sentiment and a shift in demand from branded consumer goods to private label and discounted products. Intensifying competition for branded consumer good companies will require innovation and premiumization to maintain market share, with spending in the area weighing on cash flows.

Media and entertainment.  The media and entertainment sector in Europe contributed the second highest share of weakest links through the second quarter (9). This sector remains at risk for refinancing as many issuers in the space are highly exposed to current market conditions and the probability of a higher cost of debt, particularly those heavily leveraged. Many media and entertainment issuers continue to have challenges from digital streaming services that disrupt traditional media. Adopting new practices will put downward pressure on already stretched cash flows.

Capital goods.  The capital goods sector has so far remained relatively resilient off a tailwind of government investments, decarbonization, and energy savings efforts from corporations. However, inflationary pressures, and rising elevated interest rates will slow demand and earnings in the medium term. Companies with higher leverage might be unable to refinance at an advantageous cost, increasing the likelihood for equity injections.

Credit Momentum Eases

In the 12 months ended June 2023, speculative-grade credit quality continued to show marginal movement, with net rating actions still positive, but with a negative net bias implying downgrades ahead (see chart 11). However, current trends are still far from the declines which preceded the 2009 and 2020 recent default cycles.

Chart 11

Historically, the rate of downgrades and net negative bias tend to lead the movement in the default rate by several quarters. Although currently very modest, recent net improvements in credit quality have not been enough to make up for the declines during 2020, leaving speculative-grade issuers still much more vulnerable (see chart 12). With this in mind, relative default risk is arguably higher than aggregate downgrades may imply on their own.

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.

Related Research

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• Credit Trends: Risky Credits: Europe Under Pressure, June 26, 2023
• Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain, June 26, 2023
• Economic Outlook U.K. Q3 2023: Higher Rates Start To Bite, June 26, 2023