Base Case: An Average Default Rate, But With Growing Risks

S&P Global Ratings Credit Research & Insights expects the European trailing-12-month speculative-grade corporate default rate to rise to 3.25% by September 2023 from 1.4% as of September 2022 (see chart 1).  Risks to our default forecast have increased somewhat since the second quarter, with our economists anticipating a slow-growth recession, rather than one marked by a contraction. In our downside case, the odds of this happening are higher. Like last quarter, rising inflation and higher interest rate expectations, along with the ongoing conflict between Russia and Ukraine, remain our headline risks. A result of the latter risk is the prospect for an extended period of very high energy prices as a result of EU sanctions on Russia and the curtailment of Russian gas supplies to Europe.

Consumer sentiment is poor in Europe, but it remains to be seen whether that will translate into poor hard data (see chart 2). Higher energy prices are weighing on consumer sentiment, pushing some measures to their lowest levels since the financial crisis. Meanwhile, the ECB's survey of professional forecasters in September has long-term inflation expectations at their highest since the series began. And there are already signs that consumers in the U.K. are shifting spending to staples from more discretionary destinations, combined with our economists' expectations for a technical recession in the U.K. from third-quarter 2022 through second-quarter 2023.

Chart 1

Chart 2

Optimistic Scenario: We Forecast The Default Rate Will Hit 1.5%

In what is becoming less and less a possibility, our optimistic case calls for a default rate of 1.5% through September 2023--roughly the prevailing level in September. This would require inflation to fall consistently, either allowing the European Central Bank (ECB) and Bank of England (BOE) to pause their rate hikes or even lower rates to fight a possible recession. Companies and consumers have been able to build a surplus of wealth to fall back on, which could help ride out a short, shallow recession. Although contingency measures have seemed to bring energy prices back down after Russian gas supplies were essentially cut off in August, in our optimistic scenario, we would look for the Russia-Ukraine conflict and associated sanctions to end--or see an end in sight. Given the stated positions of parties to the conflict, this appears a low-probability outcome, in our view.

Pessimistic Scenario: We Forecast The Default Rate Could Rise To 5.5%

With so many potential hazards to the European and U.K. economies and financial markets, the odds of a full-blown recession throughout Europe have been rising. If energy prices rise back to their mid-August levels through the winter or into 2024, the pinch felt by consumers and businesses would be disruptive, requiring rationing or government intervention, which could push benchmark yields higher on increased borrowing. This scenario would crimp the revenues of many companies. Primary markets would demand even higher coupons to compensate for higher policy rates put in place to combat supply-driven inflation.

Investors And Issuers Remain On The Sidelines Amid Volatility And Worsening Conditions

Market volatility this year continues to keep issuers and investors on the sidelines. Combined leveraged loan and speculative-grade bond issuance has fallen off markedly, posting a year-to-date total of only €88 billion through September (see chart 3). This is 65% below 2021's record pace and much lower than the roughly €180 billion average at this point in the year. Of the €88 billion thus far, nearly one-third came from January, with the February-September average at only €7.5 billion.

While issuers may have slightly higher cash balances on hand than is typical, and most debt is maturing well past 2023, the ability to service existing debt will likely become more difficult as rates continue to rise and revenues start to flag. In such a scenario, a continued frigid primary market would pose a major obstacle to any speculative-grade issuers in need of new funding. We expect markets to remain inactive until interest rates (and inflation) start stabilizing.

Chart 3

Financing conditions for loans to enterprises (as measured by the ECB's euro area bank lending survey) also tightened in the third quarter and are expected to continue to do so--even more than during the height of the pandemic in mid-2020 (see chart 4). The third quarter's tightening was in response to increased risks and decreased risk tolerance among senior loan officers. For the fourth quarter, loan officers expect significantly stronger net tightening in response to economic uncertainties as well as further monetary policy tightening.

Chart 4

Market Pricing Appears Largely Appropriate

Through Oct. 31, the speculative-grade bond spread reached 580 basis points (bps), up from 331 bps at the end of 2021 (see chart 5). The spread has been exceptionally volatile since January, reaching a 2022 high of 668 bps on July 6. Since then, spreads have both widened and tightened, but nothing above the July peak. Spreads widened from mid-August through the first half of October, likely in response to the threat that rapidly rising gas prices pose for the European economy, but they've fallen back since, in line with declining gas prices.

Spreads may appear low considering the building risks globally. But this is largely because benchmark rates are also rising quickly and may mask the true level of risks normally reflected in widening spreads when economies and markets stumble. With benchmark rates rising at their fastest pace in decades, previously observed flights to safety may not materialize as obviously. But also supporting current spread levels is corporate earnings that have remained stable in the past few quarters even as inflation has risen. Cash buffers built up during the pandemic have also allowed many issuers to avoid higher interest rates by lessening their needs for new debt issuance.

The relative risk of holding corporate debt can be a major indicator of future defaults because companies face pressure if they are 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. At current spreads, our baseline default rate forecast of 3.25% is roughly in line with or slightly above what the historical trend would suggest.

Chart 5

Based on broad measures of financial market sentiment, economic activity, and liquidity, we estimate that at the end of September, the speculative-grade bond spread in Europe was about 57 bps above our estimate of 683 bps (see chart 6).

The gap between the actual and estimated spread implies that despite numerous headwinds and current volatility, fixed-income investors in Europe are generally pricing in risk appropriately, if not slightly conservatively, for now. Even so, with benchmark yields having risen so much from the start of the year, current spread levels may mask the credit risks associated with higher interest rates.

Chart 6

Some Rate Sensitivity Among The Lowest-Rated Debt

Much of the lower-rated debt ('B-' and below) in Europe is in the form of floating-rate loans, whose benchmark interest rates are rising in both Europe and the U.S. (see chart 7). EURIBOR remains well below LIBOR but is rising fast, and many loans have very low floors--sometimes zero. If this trajectory continues, higher rates will start cutting into profit margins for these issuers, giving them less room to maneuver, particularly in the event of an economic slowdown or recession.

Chart 7

Overall speculative-grade debt maturing through 2023 is still relatively low, at €111.7 billion. Through 2026, however, about €162 billion of debt rated 'B-' or lower will mature, with 62% of that in floating-rate loans. Moreover, many sectors that lead in floating-rate debt rated 'B-' or lower are the most consumer-reliant--led by media and entertainment, consumer products, and retail/restaurants (see chart 8).

Chart 8

Consumer Strength Remains Key For Weaker Issuers

One key point we're watching is consumers' ability to continue propping up demand amid high energy prices, rising inflation, and slowing growth. Their ability to do so will undoubtedly be challenged later this year as temperatures fall and home heating requirements rise. Among our weakest rated issuers, over half of those rated 'CCC'/'C' are from consumer-reliant sectors and capital goods (see chart 9). Our 'CCC'/'C' default rate reached nearly 50% during the peak of the pandemic in late 2020, implying the potential for very high default risk should a worst-case scenario play out.

Chart 9

Credit Momentum Remains Positive, But Could Be At A Turning Point

In the 12 months ended September 2022, speculative-grade credit quality was relatively stable, with net rating actions still in positive territory, alongside a slightly negative net bias (see chart 10). This was little changed from the rating action trends over the prior 12 months. The speculative-grade net rating bias (the positive bias minus the negative bias) declined to -4.6%, following an all-time high of -3.6% at the end of June 2022.

Chart 10

History shows that the rate of downgrades and net negative bias tend to lead the movement in the default rate by several quarters. Current downgrade rates and bias reflect a likely turning point in credit momentum, which should lead to more defaults, but this deterioration is still very mild.

Recent improvements in credit quality have not been enough to make up for the declines during 2020, leaving speculative-grade issuers still much more vulnerable than historically (see chart 11). And while our base-case assumption is that the eurozone will barely grow in 2023, S&P Global Ratings economists' odds of a full-fledged recession in 2023 have increased to 47%. Due to this increasing likelihood, we expect economic growth to slow meaningfully, which could strain many of the weakest borrowers.

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 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.

We note that two defaults in the second quarter, from Petropavlovsk PLC and EuroChem Group AG, were captured as defaults from the U.K. and Switzerland, respectively, due to the locations of incorporation and corporate headquarters. The ratings on these issuers were subsequently withdrawn as of April 15 because these were considered to be entities with substantial presences in Russia. We do not include Russia in our definition of Europe. If we were to remove these issuers from the count of defaults, the 12-month-trailing default rate ended September 2022 would have been 0.79%, down from the 1.05% reported throughout this report. Adjustments of similar magnitude would appear for default rates ended in April and May 2022, as well as for future rates.

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