S&P Global Ratings Credit Research & Insights expects the U.S. trailing-12-month speculative-grade corporate default rate to fall slightly, to 3.75% by June 2025 from 4.8% in June 2024 (see chart 1).  Despite recent concerns about a slowdown and the recent market reaction to those concerns, we continue to think that the default rate will decline over the next 12 months. Many supportive trends are in place: The very high level of refinancing and repricing activity (particularly among leveraged loans) is providing near-term liquidity relief, second-quarter earnings continue to be resilient, and consumer spending is holding up.

However, the slow cooling of inflation and slow descent of interest rates remain challenges as we expect economic activity to weaken as part of a soft landing. The Federal Reserve's cautious approach to monetary policy may mean that rates will fall more slowly than they rose; similarly, we expect a decline in defaults that isn't as quick as the rise that we've seen in defaults since the start of 2023.

Chart 1

In our optimistic scenario, we forecast that the default rate could fall to 2.75%.  In this scenario, a faster-than-expected cooling of inflation leads to a faster-than-expected decline in interest rates. But so far, this has proven elusive. This kind of a decline in interest rates would need to offset the slowdown in growth that we expect in coming quarters--but growth could also surprise to the upside (as it has in the last year or more).

Even in this scenario, we'd expect the default rate to fall less quickly than it rose.

In our pessimistic scenario, we forecast that the default rate could rise to 6.25%.  Our pessimistic scenario is still predicated on economic growth slowing to a crawl or even turning negative.

A recession is not in our economists' base case, even after recent jobs readings (see "A Cooling U.S. Labor Market Sets Up A September Start For Rate Cuts," published Aug. 6, 2024). But recent market volatility sparked by weak economic data has revealed a heightened vulnerability to rapid widenings of spreads and primary-market freezes.

This kind of outcome isn't unusual in recessions, but because the proportion of issuers rated 'B-' or below is still high, the rated population may also be more vulnerable to liquidity pinches amid falling revenue (see chart 2).

Chart 2

Vulnerability Revealed On The Final Approach To A Soft Landing

The Aug. 2 nonfarm payrolls report--which some seemed to interpret as the first warning sign of a major slowdown--was followed by one of the fastest widenings of bond spreads since March 2020 (see table 1). Over the previous 18 months, markets have often anticipated and reacted to economic data releases negatively if the new data implied elevated inflation, forcing the Fed to keep rates high. However, this instance was different, in that markets implied this was the first sign of a recession.

Table 1

Soon after the jobs figures were announced, global equity markets experienced sharp losses, which were likely made worse by the unwinding of the yen carry trade. A rebound followed, but we think it may be premature to say the volatility has ended. One data point isn't enough to guarantee that a major economic downturn is imminent, but the swift reaction from the financial markets might have exposed a heightened level of underlying vulnerability as the economy appears closer to achieving a soft landing.

Global arbitrage structures (such as the carry trade) are also factoring into the market's vulnerability, and yet another factor is the relative "richness" of many assets right now. Speculative-grade bond spreads hit new all-time lows more than 30 times this year, and they continued to be tight at the beginning of August.

This is even more pronounced when speculative-grade bond spreads are compared to underlying corporate yields (see chart 3). The two series often move in similar trajectories, but the divergence that began about nine months ago is now as wide as it's ever been, reflecting the high prices that investors are paying on instruments that are costing lenders more and more to maintain.

Chart 3

Countering these factors that are adding to the market's vulnerability, in our view, are many positive underlying forces that are easy to overlook.

• Corporate earnings have remained positive, if not increasing this year (see "Corporate Results Roundup Q2 2024," published Aug. 5, 2024), with earnings growth for the companies that make up the S&P 500 surpassing 10% through the last four quarters.
• There has been hundreds of billions of dollars in refinancing and repricing activity in the first half of 2024--a positive development for issuers even though the strong demand for debt may be pushing spreads to levels that are ripe for a correction. This activity has eased near-term liquidity concerns and enabled issuers to push out their maturity profiles and secure savings from loan repricings.
• And if market expectations for roughly 200 basis points (bps) in cumulative rate cuts by the Fed over the next 12 months prove true, it could add to the tailwind for loan issuers (see chart 4). They were hit hard by the rate-hiking cycle, but they've already secured lower spreads this year--which is estimated to have already saved them billions in financing costs.

Chart 4

The default rate often retreats from relative peaks at roughly the same pace they rose to them. Assuming that the 4.9% default rate in April 2024 was a relative peak, this suggests that the default rate in June 2025 would be approximately 2%--which seems very optimistic in the current environment. Given the gradual decline in inflation, the gradual decline in interest rates, and a rating distribution that remains relatively vulnerable, we believe it's more likely that the default rate will decline at a slower pace, similar to the pace of its decline in 2016.

Bond Spreads Have Been A Good Indicator Of Future Stress

Bond spreads may have widened quickly in the week through Aug. 5, but they have tightened since. As shown earlier, bond spreads have spent the better part of 2024 setting new lows, supporting a wave of general optimism.

The U.S. speculative-grade corporate spread indicates future defaults based on a roughly one-year lead (see chart 5). The average speculative-grade bond spread--at 250 bps in June--implies a much lower default rate by June 2025. Even loan spreads--which ended June at 460 bps--remain relatively favorable given the large percentage of leveraged loans in the U.S. that are rated 'B' and 'B-'.

Chart 5

The corporate distress ratio is a more targeted indicator of future defaults across credit and economic cycles, especially during periods of less stress; it indicates future defaults with a roughly nine-month lead. With this in mind, the 5.9% distress ratio in June would correspond to a default rate of approximately 2.5% in March 2025 (see chart 6).

Chart 6

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 the average U.S. speculative-grade bond spread in June was 236 bps below the implied level (see chart 7).

Our estimated spread has been elevated (relative to the actual bond spread) for a prolonged period. The recent market volatility, which included a rapid widening of spreads, seemingly supports this observation.

Chart 7

Markets Remain Receptive, Helping Companies Reduce Their Upcoming Maturities

Optimistic spreads often signal opportune times for companies to come to the market, and spreads this year have certainly reflected that. A total of $568.3 billion in high-yield bonds and leveraged loans was issued between January and July--second only to the record $753.3 billion issued during the same period in 2021, and twice the amount issued during the same period last year (see chart 8).

Chart 8

Companies used much of this issuance to refinance existing debt, and since the beginning of 2024, rated speculative-grade companies have reduced the amount of outstanding debt that is due through 2026 by 32.5%--to $618 billion from $820 billion (see chart 9). This will help ease near-term liquidity needs for many companies; this, in turn, helps ease default risk.

Chart 9

A Trend Of Bullish Market Conditions And Stabilizing Credit Indicators

Market signals have been bullish, but many other credit and economic indicators remain more challenging (see table 2). Bank lending conditions continue to tighten, the yield curve has been inverted for nearly two years, and the number of weakest links is still elevated. (Weakest links are issuers rated 'B-' or lower by S&P Global Ratings with negative outlooks or ratings on CreditWatch with negative implications.) Credit conditions appear to be stabilizing, but defaults remain slightly above the long-term average.

Table 2

Negative Rating Momentum Slows

Upgrades and downgrades over the last 12 months have balanced one another out, but we expect the number of negative rating actions to increase since the negative bias for issuers rated 'B-' or below remains elevated (see chart 8). In light of this modestly negative rating momentum, a major spike in defaults appears to be unlikely in the near term.

Chart 10

In the second quarter, just two of the 13 sectors had a positive net bias, but six had negative net rating actions (see chart 11). (We define net bias as the share of issuers with ratings that have positive bias--meaning ratings with positive outlooks or ratings that are on CreditWatch with positive implications--minus the share of ratings that have negative bias.)

Chart 11

Consumer-reliant sectors accounted for 51% of U.S. defaults in 2023, and the state of the consumer deteriorated in the first half. High interest rates and persistent inflation have depleted consumer savings and lowered discretionary income, particularly for lower-income borrowers. The consumer products sector had the highest number of weakest links at the end of June, with 41.

The health care sector had the second-highest number of weakest links in June, with 35. This sector is more vulnerable to cash flow disruptions amid high interest rates and inflation given its larger share of issuers rated 'B-' or below that have floating-rate debt. These highly leveraged companies have been struggling to generate adequate sustained free cash flow, and there is also execution risk, with labor costs weighing on these companies amid persistent personnel shortages.

We expect this credit deterioration to slow in the second half as demand normalizes and inflationary pressures moderate. But defaults in the sector remain historically high.

The media and entertainment sector had the third-highest number of weakest links in June, with 32. It was one of two sectors that saw 10 defaults in the first half of 2024 in the U.S.--topping all of the other sectors--and it led the count in 2023. Slowing subscriber growth (caused by increased prices and budget cuts) is helping near-term profitability, but at the cost of sustainable subscriber growth. In addition, sticky inflation and higher-for-longer interest rates may continue to weaken consumers' discretionary spending, especially for media.

While issuers in this sector refinanced large amounts of debt in the first half, helping to curb near-term risk, lower-rated companies ('B' or lower) with high leverage and weak competitive positioning continue to confront challenges in refinancing upcoming maturities.

Downgrades of speculative-grade issuers have increased since the start of the pandemic, and the share of issuers rated 'CCC' to 'C' has grown (see chart 12). However, following the increase in defaults in 2023, the proportion of these issuers has started to decline in the last six months. 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 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 a default rate of 2.75% in June 2025 (45 defaults in the trailing 12 months) in our optimistic scenario and 6.25% (103 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

• Economic Research: A Cooling U.S. Labor Market Sets Up A September Start For Rate Cuts, Aug. 6, 2024
• U.S. Corporate Credit Outlook Midyear 2024: Steering Toward Sunlight, Aug. 1, 2024
• Default, Transition, and Recovery: 2023 Annual Global Corporate Default And Rating Transition Study, March 28, 2024