We expect corporate defaults to rise as the coronavirus pandemic unleashes economic and financial turmoil around the world. To address questions about the impact of macroeconomic shocks on default rates, we constructed three scenarios of increasing severity.
Actual default rates will depend on the length and severity of the coronavirus-driven downturn, the sector a company operates in, and impact on the company itself.
Our scenario analysis finds the global default rate would climb to 6.8% in one year in a sharp but short downturn, and to 16.1% under conditions similar to the global financial crisis of 2008-09. In February this year, the default rate on speculative-grade debt was 3.1%.
In a scenario in which a sharp contraction in the first half of this year turns into a recovery late in the year, the speculative-grade default rate for non-financial and financial companies would climb to 6.8% over the next 12 months.
If, however, economic and financial conditions were to weaken much more, and turn similar to those of 2008-09, the default rate would jump to 16.1% in a year. In an extremely severe recession, worse than the last crisis, it would rise to 20.8%.
The coronavirus pandemic and restrictions imposed to limit contagion have led to severe economic and financial stress around the world. We expect overall GDP growth in the G20 economies to fall by 0.5% this year.
Sharply lower economic activity, coupled with the fall in oil and asset prices, have exacerbated credit stress for companies in many sectors and regions. These developments have prompted several policy initiatives to offset the impact on the economy and financial markets.
There is a greater than usual degree of uncertainty around macroeconomic outcomes over the coming year. We have constructed three scenarios as follows:
Scenario 1: A sharp economic contraction, followed by a recovery. This scenario assumes a severe disruption in economic activity in the first half as efforts are made to contain the virus, accompanied by significant monetary and fiscal stimulus to offset the disruption and support a recovery once the virus is contained.
In this scenario, GDP growth would decline in the US and major European economies in the second quarter and weakness would persist into the third quarter, followed by a recovery in the fourth quarter. In this sharp, but relatively short-lived downturn scenario, the US unemployment rate would reach an average of 6.1% over the three months ending in February 2021 (against 3.5% in February 2020).
High-yield spreads, a measure of market perception of credit risk, would increase to 1,060 basis points in the next three months and decline gradually for the rest of the year, although not back to the level of 366 basis points in the fourth quarter of 2019.
The global speculative-grade default rate would rise to 6.5% by the end of 2020 and to 6.8% by February 2021. In the US, the rate would increase to 7.7% from the current level of 4.5% by the end of 2020. In Europe, it would rise to 4.8% from 1.5%.
Scenario 2: Recessionary conditions similar to 2008. This scenario assumes as the virus continues to spread and restrictions on movement are extended, economic disruption and financial market turmoil create recessionary dynamics that persist for a 12-month period.
In this scenario, the high-yield spread in the US reaches the 2008 recession peak of more than 1,800 basis points by the end of April, from 500 basis points at the beginning of March. The US unemployment rate would rise to 10.0% by the end of August, from 3.5% in February.
In such a scenario, the global speculative-grade default rate would increase to 14.2% by year-end 2020 and to 16.1% by February 2021. These levels, if realised, would surpass the peak of 13.4% during the financial crisis. One reason is there is now a larger share of lower-rated issuers compared with 2008.
In the US, the speculative-grade default rate would increase to 16.2% by year-end 2020, surpassing the peak of 14.7% in 2009. In Europe, the rate would increase to 12.8%, close to the peak of 13.1% seen in 2008.
Scenario 3: An extremely severe recession, worse than 2008. Under this scenario, containing the virus proves to be extremely challenging, economic activity is severely curtailed and business and consumer confidence collapse.
The consequent recession would be very deep and unfold more rapidly than in the prior scenario. The high-yield spread would hit an unparalleled 2,500 basis points by the end of April, while the US unemployment rate would soar to 15% by the end of May, higher than in the global financial crisis.
This extreme scenario implies severe economic and financial stress, in which the high-yield market is closed to almost all issuers for the length of the stress period.
The global speculative-grade default rate would increase to 18.3% by the end of 2020 and to 20.8% by February 2021. The default rate would increase to 18.4% in the US and to 21.7% in Europe.