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With benchmark interest rates set to fall in most major economies and spreads on corporate debt remaining remarkably narrow, defaults have likely peaked—but any decline won't come as fast as the ascent. Distressed exchanges reached their highest level in 15 years as the leading cause of defaults so far this year.

What We're Watching

Financing conditions look set to improve for corporate borrowers in Europe and the U.S. against the backdrop of the European Central Bank having lowered its key interest rate for the first time in almost five years and the U.S. Federal Reserve poised to begin a cycle of monetary-policy easing. While the market volatility that materialized has evaporated for now, underlying credit trends show resilience and improvement at most rating levels—punctuated by continued sector divergence and weakness for borrowers at the lower-end of the credit spectrum.

Markets remain as vulnerable as ever to volatility and negative events. But despite this heightened vulnerability, credit trends are showing relative resilience.

As such, global corporate defaults should begin to decline in earnest. But the descent will almost certainly be slower than the rise we've seen since the start of last year. Since the start of 2023, 240 corporate issuers have defaulted—with the global tally reaching 87 this year-to-date through July, marking just above the five-year average of 86 and slightly below the 2023 year-to-date count of 91.

Accounting for two-thirds of July's nine total defaults, distressed exchanges remain a leading cause of defaults. There have been 45 distressed exchanges in the first seven months of this year—18% more than in the same period last year and the highest level since 2009.

This increase comes, in part, from a growing number of repeat defaulters (or companies that have already defaulted at least once), which have accounted for close to one-third of year-to-date defaults. The number of repeat defaulters has increased in recent years as more companies, markets, and investors become increasingly comfortable with distressed exchanges and high leverage in their capital structures, many of which were set up during—and in anticipation of—a prolonged period of low interest rates.

What We Think And Why

We expect the European trailing-12-month speculative-grade corporate default rate to fall to 4.25% by June 2025, marking a slight decrease from the 4.7% default rate through this June but still elevated per historical levels. All-in borrowing costs remain high, and the prospect for a rapid decline in defaults appears remote—which has made it more difficult for issuers (especially at the bottom of the credit stack) to service their debt. With 26 corporate defaults to date this year, Europe is the only region where defaults have exceeded 2023 levels, to the tune of a notable 86% increase and the highest number tallied since 2008. While we expect the ECB to continue with quarterly cuts to its key rate, this path is far from a certainty.

Similarly, we forecast the U.S. corporate default rate to fall slightly to 3.75% by June of next year (from 4.8%) despite recent concerns over a slowdown in the world's biggest economy and corresponding market reactions. Several supportive trends may help the current default environment in the U.S., including: high levels of refinancing and repricing activity (particularly among leveraged loans), which is providing near-term liquidity relief; resilience in second-quarter earnings; and the fact that consumer spending has held up fairly well despite the depletion of household savings.

Looking beyond defaults, corporate borrowers can suffer significantly from ratings downgrades—especially into speculative-grade territory ('BB+' or lower) as fallen angels. Even with the narrowing in absolute credit spreads in the first half of this year, the cost of falling to (or close to) speculative grade remains significantly high from a historical perspective. The percentage differential in spreads across all rating levels peaks at 28% between 'BBB-' and 'BBB.' The 'BBB-' rating is just a notch above the actual tipping point into speculative-grade, where the percentage differential is also elevated at 25%.

What Could Change

Although a recession is not our economists' base case, a sudden or severe slowdown would quickly boost default rates given the still-high proportion of 'CCC/CC' borrowers (which account for 9% of the total speculative-grade portfolio). These borrowers have had very limited market access for several years, and are characterized, in many cases, by poor cash flow. Recent global market volatility has highlighted the vulnerability to negative surprises and quickly changing investor sentiment. Capital markets effectively closing to weaker issuers would weigh on many 'B-' borrowers that have already experienced a higher rate of distressed exchanges this year.

If the eurozone economy suffers an unexpected downturn, spreads could widen faster than in the past, squeezing liquidity when needed most and pushing defaults toward our pessimistic scenario of 6%.

In the U.S., too, recent market volatility sparked by weak economic data has revealed a heightened vulnerability to rapid widenings of spreads and primary-market freezes. Our baseline view of a soft landing for the U.S. economy isn't without risks: We believe the probability of a recession starting within the next 12 months is elevated, at 25%-30%.

A potentially disruptive U.S. election also looms. Any disorderly reaction in the financial markets to actual and perceived risks could lead to a higher chance of a recession, as companies cut back on investment and headcount. Because of growing concerns about the labor market's resilience and increasing delinquencies, consumer-facing sectors continue to be among the most vulnerable and among those that are most likely to lead defaults. In our pessimistic scenario, we forecast that the U.S. default rate could rise to 6.25%.

Writers: Joe Maguire and Molly Mintz