S&P Global Ratings Credit Research & Insights expects the U.S. trailing-12-month speculative-grade corporate default rate to reach 4.75% by December 2024, from 4.5% in December 2023 (see chart 1).   In our base case, we expect the default rate to finish the year higher than it is currently. This may however, include a peak default rate earlier in the year as we anticipate this year to see a continuation of the trends seen last year. This includes more defaults, a high proportion of distressed exchanges, and higher contributions from sectors with a consumer-reliant nature or those with currently weak cash flow and high debt such as media and entertainment, consumer products, and health care.

We expect interest rates to ease, but do not anticipate the Federal Reserve to cut rates before mid-year, keeping interest burdens high through most of 2024. On the positive side, economic growth has been more resilient than anticipated and should remain just above long-term potential this year, although we expect it to slow. This should help support revenue enough to ward off more elevated default rates ahead.

Chart 1

In our optimistic scenario, we forecast the default rate could fall to 3.25%.   In this scenario, economic growth would surprise to the upside once again while inflation and interest rates fall. If consumers remain resilient, this would result in a "soft landing" for the economy and financial markets.

The last time the U.S. saw a soft landing was in the mid-1990s, when the default rate peaked at 4%--roughly the same level as through December 2023. This scenario would give the Fed space to lower rates prior to mid-2024. The earlier interest rates decline, the more debt in need of refinancing will be able to avoid the current elevated interest rates. Still, taking risks with the timing of interest rate cuts will only save borrowers so much and comes with plenty of downside risks.

In our pessimistic scenario, we forecast the default rate could rise to 6.75%.   In this scenario, economic growth would slow to a crawl, or possibly enter recession. While we anticipate core inflation to fall this year, stickier or higher levels would be a considerable obstacle for borrowers if the Fed keeps rates elevated, providing a double challenge to firms' ability to service debt. For now, we view a recession as less likely, but not out of the range of possibilities, and consumer finances--while still arguably healthy in aggregate--are starting to weaken.

Deepening Divergence: Improved Market Sentiment, But Stretched Borrowers

Market sentiment has clearly improved since the start of fourth-quarter 2023, with spreads falling and issuance resuming among even the lowest rungs of speculative-grade--'CCC/C' bonds saw $1.5 billion in issuance in December and January (see chart 2). Although only across two issuers, these deals saw an average coupon rate of 7.9%--less than the 8.3% average 'B' yield currently in secondary markets.

Chart 2

Recent issuance trends mark an improvement relative to the last two years, and much of recent activity has been used for refinancing.

This has helped reduce the amount of speculative-grade debt coming due in the next year or two (see chart 3). But while issuers have been able to find funding for existing debt, the cost to maintain it has risen since 2022.

Chart 3

Higher interest rates will remain a challenge for issuers. Despite the boost in market sentiment, credit fundamentals remain strained. This is particularly true for the weakest ratings, which are starting to represent more of the speculative-grade population (see table 1).

Issuers rated 'B-' and below have had very low free operating cash flow on average and low interest coverage. We expect these measures to improve this year, but lingering effects from 2022 and 2023 may keep the default rate elevated around current levels for most of this year.

Table 1

Risk Tolerance Returns

Speculative-grade bond spreads recently dipped below 300 basis points (bps), reflecting increased optimism and risk appetite among investors as growth remains strong and inflation gradually descends. 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 4). At 298 bps in December 2023, the speculative-grade bond spread implies a much lower default rate by December 2024. Even loan spreads--at 490 bps at the end of December--remain relatively favorable given the large percentage of leveraged loans in the U.S. rated 'B' and 'B-'.

Chart 4

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 6% distress ratio in December would roughly correspond to a 2.4% default rate for September 2024 (see chart 5).

Chart 5

Bond Spreads May Still Be Too Optimistic

Using the CBOE Volatility Index (VIX), the ISM Purchasing Managers' Index, and components of the money supply, we estimate that in December 2023, the average speculative-grade bond spread in the U.S. was about 202 bps below the implied level (see chart 6).

Market volatility remains relatively low, particularly compared with 2022, which supports a lower spread estimate. On the other hand, certain 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 6

Improving Market Conditions Clash With Weaker Fundamentals

Recent market signals may appear rather bullish, but many other credit and economic indicators have been deteriorating, if slowly (see table 2). Bank lending conditions continue to tighten, the yield curve remains inverted after over a year, 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. While speculative-grade maturities appear manageable in 2024, they are notably higher in 2025 and beyond. Credit conditions will remain restrictive as refinancing risk climbs entering 2024. We also don't expect the Fed to cut rates until around June, implying little relief for borrowers in the near term.

Table 2

Negative Rating Momentum To Hit Some Sectors More Than Others

Negative rating actions have remained moderate, but we expect them to increase. Speculative-grade credit quality has proven largely 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 7).

Chart 7

In the fourth quarter, just three sectors had a positive net bias, and all but four sectors had negative net rating actions (see chart 8). (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.)

Chart 8

Four sectors combined account for nearly 69% of speculative-grade issuers with a negative bias and over 73% of weakest links.

The health care sector led weakest links in 2023 with 40 issuers, slightly outpacing the consumer/service sector--which previously led--with 39. Health care is more vulnerable to cash flow disruptions amid higher interest rates and inflation given its larger share of weaker-rated issuers (those rated 'B-' and below) with floating-rate debt.

These highly leveraged companies have struggled to generate adequate sustained free cash flow, with particular focus on labor costs, given persistent shortages of health care personnel. We expect default activity to remain elevated in the sector as many of our rated companies face 2025 maturities amid refinancing challenges.

The consumer/service sector had the second highest number of weakest links and potential downgrades through the fourth quarter (potential downgrades are issuers rated by S&P Global Ratings with a negative outlook or a rating on CreditWatch negative). Consumer-reliant sectors accounted for 51% of defaults in the U.S. in 2023, and the state of the consumer continues to be the biggest wild card right now. Similar to health care, the consumer/service sector will likely continue to face strained cash flow given higher for longer interest rates.

Media and entertainment had the third-highest number of weakest links through the fourth quarter and led defaults in the U.S. in 2023. Here again, refinancing and elevated financing costs remain the key risks, especially among lower-rated companies. While some companies extended maturities last year, there remains a high volume of upcoming maturities in 2025 and 2026.

As rates stay higher for longer, we expect weakening consumer balance sheets to squeeze consumer spending on discretionary items (like streaming services) in 2024. Further, persistently high interest rates put refinancing pressure on lower-rated companies with near-term maturities, as many are unable to survive with higher interest burdens.

That said, there is divergence in the media and entertainment sector. Some issuers are underpinned by improved fundamentals amid the continued normalization of social activities, such as hotels, gaming, and leisure. Others, such as legacy media, continue to suffer from increasing dependence on digital platforms and digital distribution after the pandemic.

However, after a long quiet period, we expect advertising in legacy media to improve in the second half with the upcoming presidential election in the U.S. In addition, the resolution of the writers and actors strikes also bodes well for the sector, though they have caused the industry to reevaluate its content spending. While likely to improve this year, spending will take several months to normalize.

Chart 9

Chart 10

As downgrades of speculative-grade issuers have increased since the outbreak of the pandemic, the share of issuers rated 'CCC' to 'C' has grown (see chart 11). More recently, the proportion of 'CCC to 'C' ratings has continued to increase while the proportion of 'B-' ratings have been falling. These lowest-rated issuers have historically had a much higher default rate, and we expect them to remain stressed over the next few quarters.

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 be 3.25% in December 2024 (55 defaults in the trailing 12 months) in our optimistic scenario and 6.75% (114 defaults in the trailing 12 months) in our pessimistic scenario.

We determine our forecast based on various 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: Tug Of War (January 2024), Jan. 30, 2024
• Economic Outlook U.S. Q1 2024: Cooling Off But Not Breaking, Nov. 27, 2023
• 2022 Annual Global Corporate Default And Rating Transition Study, April 25, 2023