Our Base Case Incorporates Generally Stable Credit Quality

Baseline: S&P Global Ratings Credit Research & Insights expects the European trailing-12-month speculative-grade corporate default rate to level out at 3.75% by March 2025.  This would be down slightly from the 4.1% default rate for the 12 months through this April, but it would still be elevated on a historical basis (see chart 1).

Persistently high market rates are making it more difficult for weaker issuers to service their debt, and while we expect the European Central Bank (ECB) to start cutting rates next month, the rate-cutting cycle may be slower or include fewer cuts than we had anticipated at the start of this year. We expect sluggish economic growth in 2024 for the eurozone (0.7%) and the U.K. (0.3%), but these still represent higher growth rates than they had in 2023, and S&P Global Ratings economists don't expect a recession in any country this year or next. Nonetheless, the longer this already protracted period of higher rates and sluggish growth persists, the harder it will be for more levered firms with poor cash flow to keep up.

Europe may see an extended period of steady default rates--similar to the 10-year stretch at 2% after the financial crisis. But this time, it would be with higher rates persisting, which could lead to a higher sustained default rate, between 3% and 4%.

Chart 1

Optimistic scenario: We forecast that the default rate could fall to 2%.  Economic resilience in Europe would need to continue or even expand beyond what our economists expect in their base case; this could include a more aggressive decline in core inflation both in Europe and globally.

Current debt market pricing appears supportive, and there has been a record amount of issuance used year to date for refinancing by 'BB' and 'B' rated issuers. A stronger resumption of 'CCC'/'C' rated debt issuance would offer needed support as these companies' maturities get closer.

Pessimistic scenario: We forecast that the default rate could rise to 5%.  Growth in Europe could slow below our baseline forecast, which would further stress cash flow amid high interest rates. Sponsors have withdrawn support on smaller entities, and some issuers with larger debt amounts have started to exploit borrower-friendly documentation, triggering more distressed exchanges of late (see chart 2). If the reputational risk to issuers of using more aggressive restructuring tactics subsides, we could see even more distressed exchanges.

We've also seen surprisingly quick downgrades for some large issuers as investor tolerance for prolonged periods of negative free cash flow has waned, while other large issuers have been incentivized to employ the full scope of their covenant flexibility to preemptively restructure parts of their debt piles. These types of tactics--if their use becomes more widespread--could sour market sentiment and keep the default rate elevated, above our baseline projection of 3.75%. If there's an unexpected economic slowdown, the default rate could climb beyond that, toward 5%.

Chart 2

A Very Strong Start To 2024 For Issuance Levels

In Europe, combined high-yield bond and leveraged loan issuance had a very strong start to 2024. Issuance through April outpaced every year's comparable total except 2021, when financing conditions were extremely favorable for speculative-grade issuers (see chart 3). The pace of bond issuance in 2024 has been far stronger than the pace of leveraged loan issuance, and refinancing drove much of the issuance overall, helping to reduce companies' near-term liquidity risk.

Chart 3

Even if issuance falls off in the second half of the year, upcoming maturities in 2024 remain very manageable (see chart 4). As of April 1, 2024, €32.6 billion of speculative-grade debt was set to mature over the remainder of this year, and only €1.7 billion of that debt is rated at the 'CCC' category or below. But the pace of maturities picks up after that: In 2026, it will reach €185 billion, €118 billion of which is rated 'B' or below. Depending on economic and interest rate conditions in the next 12 months, these later maturities could prove tough to refinance.

Chart 4

Risk Sentiment Improves, But Debt Costs Remain High

European banks' credit standards for loans to companies tightened in the first quarter of 2024, albeit less than they did during the previous quarter and less than banks had anticipated a quarter earlier (see chart 5). Banks expect a lower level of tightening in the second quarter than in the first quarter. Though a relative easing of financing conditions has been in place for the last several quarters, the cumulative net tightening over the last two years remains significant.

As in the previous quarter, banks' risk perceptions were the main cause of the net tightening of credit standards in the first quarter of 2024. Driving those risk perceptions were the region's weak economic situation and outlook, together with credit risk for firms related to their financial situations.

Chart 5

The relative risk pricing of both bonds and loans (via spreads) reflects markets' declining credit risk perceptions (see chart 6). The relative risk of holding corporate debt can be a strong indicator of future defaults because companies face pressure if they're 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. Given current spreads, our baseline default rate forecast of 3.75% is above what the historical trend suggests.

However, in contrast to spreads, current yields remain comparably elevated (particularly on loans), increasing the all-in costs of debt that issuers must contend with, regardless of relative risk perceptions. While the European Leveraged Loan Index (ELLI) spread may have fallen 77 basis points (bps) over the last 12 months, the ELLI yield-to-maturity declined only 29 bps, to 8.64% in April. In our view, since the start of the current rate-hiking cycle in 2022, the trend in defaults has been more similar to the trend in yields than the trend in spreads.

Chart 6

Considering broad measures of financial market sentiment, economic activity, and liquidity, the average speculative-grade bond spread in Europe was, in March, about 209 bps below our estimate of 553 bps (see chart 7). The gap between the actual spread and the estimated spread implies that bond markets may be overly optimistic in their current stance. It also supports the argument that yields, rather than spreads, are the better indicator of financial stress in current conditions.

Chart 7

Stronger Growth In 2024 May Help Offset Debt Burdens

Factors supporting solid consumer demand should benefit lower-rated issuers. Economic growth in the euro area and in the U.K. should accelerate this year and next, with the euro area unemployment rate increasing only slightly. In addition, euro area consumer price inflation slowed to 2.6% in March 2024 from 6.9% a year earlier, and it's set to decelerate further over the near term. All of this bodes well for household consumption.

This should help lower-rated issuers because 28% of issuers that are rated at the 'CCC' category or below are in consumer-facing sectors, like consumer products and media and entertainment. On the negative side, strong wage growth blunts the deceleration of consumer price inflation and weighs on corporate profits.

Chart 8

Consumer products issuers and media and entertainment issuers weren't as big a part of the 'CCC'/'C' rated population in March 2024 as they were three months before--those sectors saw two defaults each during the first quarter. Nevertheless, they're still the sectors that account for more vulnerable issuers (14% each) than any other sector (see chart 8).

The telecommunications sector also stands out because, at the end of the first quarter, it accounted for 10% of the issuers that are rated at the 'CCC' category or below--a figure that more than doubled over the course of the quarter. Credit quality deteriorated in this sector amid prolonged high interest rates--they generally constrain access to capital markets, and weaker credit ratios could punish lower-rated issuers with more leverage in their capital structures. Highly leveraged issuers, for which free operating cash flow and interest coverage are critical credit measures, are most at risk from high interest rates.

Credit Momentum Has Been Stable For A While

Current rating trends are still far from the credit momentum declines that preceded the 2009 and 2020 default cycles--an indication that there are no major spikes in defaults ahead. In the 12 months ended March 2024, speculative-grade credit quality continued to show marginal improvement. Net rating actions stayed positive, but with a negative net bias that implies more downgrades ahead (see chart 9).

Chart 9

The rate of downgrades and the net negative bias have tended to lead movement in the default rate by several quarters. Though credit quality has generally improved since 2021, that hasn't been enough to make up for the declines during 2020, meaning that speculative-grade issuers are still much more vulnerable than they've been historically (see chart 10). We therefore think that relative default risk is higher than what aggregate downgrades imply on their own.

Chart 10

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.

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