Our Base Case Assumes A Gradual Decline In Defaults

Baseline: S&P Global Ratings Credit Research & Insights expects the European trailing-12-month speculative-grade corporate default rate to fall to 4.25% by June 2025.   This would be down slightly from the 4.7% default rate for the 12 months through this June, but it would still be elevated historically (see chart 1). Consistent with the projection from our prior forecasts, this represents a declining default rate, but the decline is from a higher starting point than previously expected.

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 continue cutting rates quarterly moving forward, the rate-cutting cycle is far from locked in. We expect sluggish economic growth in 2024 for the eurozone (0.7%) and the U.K. (0.6%), but stronger levels in 2025 (1.4% and 1.2%, respectively), which should help ease default frequency next year.

This particular default cycle has arguably risen above 4% due to an increase in distressed exchanges and similar restructurings. Many lower-rated issuers have used this to ease near-term debt burdens and financing costs amid weak cash flow. Roughly 68% of all defaults this year have been distressed exchanges, up from 55% in 2022. This has arguably pushed the default rate higher than its long-term average, but the pace of such scenarios should ease as interest rates decline.

Chart 1

Optimistic scenario: We forecast that the default rate could fall to 2.5% by next March.  In this scenario, we would expect economic growth to pick up above our economists' base-case assumptions, alongside sustained inflation reduction and interest rates continuing to fall. Perhaps most critical, markets will need to open up more to 'CCC/CC' issuers in need of liquidity to manage existing debt loads, particularly as they come due in 2025 and 2026. If the default rate is at or near a peak now or in the next few months, as we previously expected, the historical trend could produce a decline in the default rate, resembling the pace of its recent increase. However, this would need stronger growth, combined with a faster than currently expected pace of both inflation and interest rate declines.

Pessimistic scenario: We forecast that the default rate could rise to 6%.  Although a recession is not in our economists' base-case assumptions, a marked slowdown or recession would quickly affect default rates given the still elevated proportion of 'CCC/CC' issuers (9% of total speculative-grade issuers) that have had very limited market access for several years, and are characterized, in many cases, by poor cash flow. Recent global market volatility has arguably exposed higher vulnerability to negative surprises and a faster change in investor sentiment. In a case where primary markets would effectively shut down for weaker issuers, this would negatively impact many 'B-' issuers that already have a higher rate of distressed exchanges this year.

Perceived And Real Strains

Early August saw, what in hindsight, was a blip of market volatility following a worse-than-expected reading for U.S. non-farm payrolls. Markets quickly interpreted this as the first sign of a recession in the U.S., and the following rise in bond spreads was swift. This became a global spike in volatility, exacerbated by the yen carry trade. It also caused European spreads to widen quickly, narrowing the gap between speculative-grade bond spreads in the U.S. and Europe that has persisted since the start of the Russia-Ukraine conflict (see chart 2). While short-lived, the intense adverse reaction indicates that markets may be more vulnerable to negative economic events than previously, which could provide immediate distress to weaker issuers, particularly in the 'CCC' category.

Chart 2

The period through July 2024 has largely been one of high investor optimism and renewed access to bond markets for European speculative-grade issuers. The year-to-date total of €100.4 billion is the second-highest year-to-date total since the record haul in 2021 (see chart 3). This is a marked improvement from 2023 and 2022, which combined accounted for only €84.1 billion, year to date. Still, 'CCC/C' rated debt remains anemic, at only €1.7 billion this year. This is coming after very low issuance in 2022 and 2023 for this rating category, producing a long stretch with little market demand and strained liquidity.

The renewed issuance has come at a cost through higher interest rates. For 'BB' rated deals, average coupons in 2024 reached 6.1%. This is roughly 1.6% higher than in 2019, and 2.7% higher than in 2021. Similar trends hold for 'B' rated bonds in Europe as well, up 92 basis points (bps) since 2019, and 284 bps since 2021, with average coupons now at 7.9%. The few 'CCC/C' rated deals that have come to market this year have had an even higher average coupon of 9%. Much of this year's issuance has been used to refinance existing debt, taking away near-term pressure, but these higher debt costs may present challenges for years to come, particularly during periods of flagging revenues.

Chart 3

However, even if issuance falls off in the second half of the year, upcoming maturities in 2024 and 2025 are more manageable after this year's heavy refinancing activity to date (see chart 4). As of July 1, 2024, €21.9 billion of speculative-grade debt was set to mature over the remainder of this year, and another €87.3 billion in 2025. This compares with €50.8 billion and €110.2 billion for 2024 and 2025 outstanding debt as of the start of the year.

Chart 4

Risk Trend Improves And Costs Remain High, All Eyes On Central Banks

European banks' credit standards for loans to companies tightened just slightly in the second quarter of 2024, once again, less than they did during the previous quarter and less than banks anticipated a quarter earlier (see chart 5). Banks expect a slightly higher level of tightening in the third quarter (5%), but still a historically modest level. Although a relative easing of financing conditions has been established for the last several quarters, the cumulative net tightening over the last two years remains significant.

Banks' risk tolerance was the main cause of the net tightening of credit standards in the second quarter of 2024, unlike the previous quarters' rising risk perceptions. Meanwhile, demand for loans by firms fell once again in the second quarter (down 7%) on rising rates and lower fixed investment.

Chart 5

The relative risk pricing of both bonds and loans (through spreads) reflects markets' declining credit risk perceptions (see chart 6). Spreads widened sharply in early August, but have tightened since. The relative risk of holding corporate debt can strongly indicate future defaults because companies are strained 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 4.25% is above historical trends.

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 and the ELLI yield-to-maturity have largely tracked each other fairly closely since the financial crisis, the two have diverged paths noticeably for the last two years. In our view, since the current rate-hiking cycle began in 2022, the default trend has been more similar to the yield trend than the trend in spreads.

Yield relief may be a slow process despite the ECB's start to lowering rates in June. As markets have indicated in early August, the yield trajectory is also a global one, largely led by the Federal Reserve.

Chart 6

Considering broad measures of financial market sentiment, economic activity, and liquidity, the average speculative-grade bond spread in Europe in June was about 279 bps below our estimate of 617 bps (see chart 7). The gap between the actual spread and the estimated spread implies that bond markets have a highly favorable view of credit prospects currently. It also supports the argument that yields, rather than spreads, better indicate financial stress in current rising default conditions.

Chart 7

Stronger Growth In 2025 May Help Offset Existing Debt Burdens

Factors supporting solid consumer demand should benefit lower-rated issuers in the near term. Economic growth in the euro area and in the U.K. should accelerate this year and in 2025, with the unemployment rate holding steady quarter over quarter (6.5%) near record lows in most eurozone countries. In addition, euro area consumer price inflation slowed to 2.5% in June 2024, from 5.5% a year earlier, and is set to decelerate more over the near term. All of this bodes well for household consumption, particularly as we expect wages to increase faster than inflation. However, this is contingent on energy prices remaining stable.

This should help lower-rated issuers because 27% of issuers that are rated at the 'CCC' category or below are in consumer-facing sectors, like consumer products and media and entertainment (see chart 8).

Chart 8

Consumer products issuers and media and entertainment issuers weren't as big a part of the number of 'CCC'/'C' rated entities in June 2024 as they were three months ago--those sectors had three defaults total during the second quarter. Nevertheless, they still account for more vulnerable issuers (16% for consumer/service and 10% for media and entertainment) than any other sector.

The health care sector also stands out, given its relatively large share of the issuers, and elevated proportion of weakest links (those issuers rated 'B-' or lower and with a negative outlook or on CreditWatch). Credit quality deteriorated in this sector amid prolonged supply-chain bottlenecks. We anticipate a reallocation of investment toward increasing capacity and a stronger supply chain, as growth investments have largely been in mergers and acquisitions. This sector has also been challenged by persistent, albeit shrinking, inflation and an unfavorable pricing.

If broadening the analysis to weakest links, the media and entertainment sector had the highest number of weakest links at the end of June, with eight (see chart 9). The sector improved in the second quarter, with expectations for second-half advertising revenue recovering, and content production returning to normal. A key risk in the sector is companies' ability to embed AI into their products.

The chemicals, packaging, and environmental services sector had the second-highest number of weakest links in June, with six. In particular, the chemicals sector is going through a slow recovery after massive destocking in the second half of 2022 through 2023. While global chemical production volumes began recovering in the first half, lower prices caused chemicals sales to fall slightly. Weakened demand for chemical products, ongoing geopolitical risks that challenge global trade and supply chains, and more aggressive financial policies remain key concerns in the sector.

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--indicating there are no major spikes in defaults ahead. In the 12 months ended June 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 10).

Chart 10

The rate of downgrades and the net negative bias have tended to lead movement in the default rate by several quarters. Although credit quality has generally improved since 2021, not enough to bring the speculative-grade rating distribution back to its relative health from before the pandemic (see chart 11). We therefore think that relative default risk is higher than what aggregate downgrades imply on their own.

Chart 11

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

• Credit Trends: Risky Credits: Positive Ratings Momentum In Europe Continues, July 26, 2024
• Credit Conditions Europe Q3 2024: Keep Calm, Carry On, June 25, 2024
• Economic Outlook Eurozone Q3 2024: Growth Returns, Rates Fall, June 24, 2024
• Economic Research: U.K. Economic Outlook Q3 2024: A Cooling Labor Market Paves The Way For Rate Cuts, June 24, 2024