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By Steve Ruh
Despite recent market volatility, our base case outlook for U.S. non-investment grade credit defaults remains constructive.
Approximately one year ago, we published a blog providing our bottom-up outlook for defaults in the U.S. non-investment grade credit market, which concluded that defaults were likely to remain below the long-term average over the subsequent 24 months. While the macroeconomic outlook is more uncertain now than at the time of last year’s estimate, our base case default outlook remains favorable, with cumulative 2022 through 2024 default rates of 2.1% and 1.8% for the U.S. high yield and leveraged loan markets, respectively.
The foundation for a low-default environment has been long in the making. Issuers entered 2022 in a position of strength following 1) strong recent economic growth that translated into earnings momentum and deleveraging following the pandemic and 2) highly accommodative capital markets that have allowed issuers to extend debt maturities at a low cost, effectively eliminating near-term default catalysts for all but the most stressed portion of the market. Additionally, the improved health of the energy sector – a frequent contributor to defaults over the past several years – has also positively affected the forward-looking default outlook. The combination of strong recent financial performance and limited near-term maturities creates a very durable situation for non-investment grade issuers, with the limited default activity that could occur largely concentrated in distressed issuers where a default is already expected by the market.
Given the more uncertain economic outlook, the team has also performed a stress case scenario that assumes a recession paired with restrictive non-investment grade capital markets through 2024. In this scenario, we estimate cumulative defaults through 2024 of 7.8% and 6.9% for the U.S. high yield and leveraged loan markets, respectively. These default estimates compare to 2008 – 2009 cumulative default rates of 18.4% and 13.4% for the U.S. high yield and leveraged loan markets, respectively. Importantly, due to the favorable maturity profile of the non-investment grade credit market, the majority of defaults would occur in 2024 – meaning that our restrictive capital markets assumption would need to be held for 30 months to drive this level of defaults. This is a highly conservative assumption and, in our view, is unlikely even in a recession scenario.
In sum, we believe current non-investment grade spreads more than compensate for what continues to be a benign base case default outlook and a conservative stress case that is approximately 50% below the 2008 – 2009 default cycle.
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