The current cycle has recorded a very rapid rise in default rates, driven by the credit effects of the coronavirus-induced recession and the stress already prevailing in some sectors like energy and retail, especially in the US before the crisis. After being quite low by historical standards for a long period, the global default rate of speculative grade companies rose rapidly to its highest levels in the past decade, doubling in just a few months to 6.6% from its 3.3% level of February 2020. The initial shock to economic activity and to financial market conditions, though the latter was only short-lived, led credit events to move rapidly between March and the summer. Accordingly, US default rates immediately moved higher from the 4% area, rapidly reaching 9% in the summer. European default rates were more resilient in the first months of the crisis, also thanks to much lower exposure to the energy sector and higher average credit quality, but then to some extent they closed the gap partially with the US, moving from a 2% starting level to 5% in autumn.
As we highlighted in previous focuses, the main drivers of the upward trend were US companies in the energy sector, challenged by depressed oil prices, which created a tough operating environment within the Oil & Gas sector, especially in the Exploration & Production and Oilfield Service subsectors. The other two sectors accounting for a large proportion of defaults in the US, and struggling more than others with pandemic-related business disruption, were Retail and Business Services.
In terms of credit quality affected, an analysis of the defaults rating breakdown probably shows the most striking divergence with previous experiences. Even at the time of writing, which is already seeing the start of a downward trend in bankruptcies, the cycle still looks almost entirely a CCC-rated story, as high and mid-rated companies still show very few defaults, close to historically low levels. Interestingly, as chart 1) shows, current BB-rated and single B-rated default rates are still quite low by historical standards for a recession, even more if we account for the severity of the 2020 contraction. In a nutshell, the chart shows that both rating categories peaked in terms of defaults at less than one third of the usual recession-high levels. On the contrary, most vulnerable and less “policy-supported” CCCrated default rates have rapidly jumped to the highest levels of the GFC, namely in the 30% area.
Another peculiar feature of this default cycle is its limited length, made quite short-lived by unprecedented interventions of both fiscal and monetary policies through a very prompt deployment of huge stimulus, ultimately preventing a credit crunch to materialize and lowering even more financing cost. For the first time in a crisis, furthermore, a strong increase in refinancing activity made default rates a lowest rating/sector story. In fact, the Fed was quite effective in keeping defaults from rising through its unprecedented active approach, entering corporate purchases for the first time, and even moving in support of fallen angels. In Europe, the combination of unprecedented fiscal measures, especially through state guarantees, and all of the liquidity measures put in place by the ECB on the monetary policy side (through TLTROs initially) also proved to be quite effective in avoiding the credit crunch risk on bank loans, the key funding channel for European companies. The latter relied quite heavily on bank loan facilities and did not need to tap the bond markets for substantial refinancing and to build cash buffers. Finally, the lowyield environment tempered defaults, too, especially among high- and mid-rated companies. With respect to the severity of GDP contraction, then, the level of the default peak looks quite low, too.
Rating agencies have progressively cut their forecasts on projected defaults.
From this respect, we stress that in the past two quarters rating agencies have progressively cut their forecasts on of projected defaults, especially in the US, where they were higher between March and the summer. Furthermore, the duration of the cycle has been shortened, as the peak until a few months ago was still projected for the end of Q1 2021, one year since the start of the crisis. Recently, on the back of better than expected year-to-date trends and improved macro perspective, Moody’s revised down its 12-month estimates, indicating as well an earlier peak in the cycle, which likely is already behind us. According to its latest projections published in the March default report, the rating agency now expects US HY and European default rates to fall, respectively, to 4.9% and to 2.8% by February 2022. The gap between the two areas should therefore remain in favour of Europe, albeit to a lesser extent than in past months. Moreover, in terms of sectoral drivers, the impact is going to turn from previous trends, as Hotel, Gaming & Leisure is expected to be among the most impacted sectors on a one-year timeframe in both advanced areas.