Our base-case European speculative-grade default forecast of 6.1% for the full year would equate to 41 companies in our rated universe defaulting by the end of the year, up from 4.8% at the end of 2011. However, in a downside scenario, the default rate may climb to 8.4% or even higher if the economic and financing environment deteriorates further due to a deeper or more protracted recession in Europe.
The renewed uncertainty regarding the solvency of certain eurozone sovereigns in the European Economic and Monetary Union since last summer marks a turning point for corporate defaults for at least three reasons:
Firstly, S&P’s economists have scaled back their base-case economic forecasts for the eurozone, as well as the UK They expect a shallow recession in the first half of 2012 in the eurozone, with countries enduring austerity measures dragging on the still positive growth that is anticipated in Germany and other Northern European countries.
Secondly, just as relevant for the default outlook given the high percentage of highly leveraged companies that still need to refinance over the next two to three years is the fragile condition of the banking industry that has become more evident over the past few months. This includes an excessive dependence on European Central Bank liquidity, the limited ability of even top-tier banks to raise unsecured funding in the debt capital markets, the requirement that banks achieve core tier one equity targets of 9% by the end of June 2012 and banks shifting business priorities back to their core market(s).
Thirdly, the phoney war of forbearance may be coming to an end. The policy of temporary relief by senior lenders for borrowers in distress is reaching its limits given the proximity to principal maturity dates in 2013-2014 and the pressure on banks to improve the quality of assets on their balance sheets.
Debt restructuring required
Most companies with private credit estimates are heavily reliant on either internally generated cash flow or debt financing from leveraged counterparties, namely banks and CLOs. Yet banks currently face the challenges of higher funding costs and a more demanding regulatory environment.
Existing CLO investors, meanwhile, will have declining capacity to refinance the debt of their portfolio companies as they reach the end of their reinvestment periods by 2014. Therefore, many of the most vulnerable companies have little choice but to continue relying on senior lenders to amend covenants as required and to hope that economic and debt market conditions will improve sufficiently to facilitate a viable refinancing before going-concern issues arise.
These most vulnerable companies will require debt restructurings a year or more before their term debt matures in 2013-2014. A substantial portion of about 55% of the 167 credit estimates that have defaulted since the end of 2007 remain highly vulnerable to defaulting again, meaning that they have a credit estimate of B- or lower.
Consequently, combining both quantitative and qualitative factors into their assessment, and taking account of the more challenging economic outlook for the next one to two years, their corporate default projections for 2012 will be revised slightly upwards.