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Default Study:
A Changing Market Composition Points To A Lower Corporate Default Rate On The Horizon In Europe
Primary Credit Analyst: Paul Watters, CFA, London (44) 20-7176-3542; paul.watters@standardandpoors.com Secondary Contact: Alexandra Krief, Paris (33) 1-4420-7308; alexandra.krief@standardandpoors.com
Table Of Contents
A Steady Stream Of Defaulters The Default Rate By Value Falls Back To Q3 2011 Levels The Portfolio Shifts Toward Speculative-Grade Ratings The Default Rate Will Likely Fall To 5.2% By March 2015 Business Services, Retail, And Transportation Head The Default Tally The Credit Quality Of U.K. Companies May Be A Cause For Concern Recovery Rates For Senior Secured Debt Are On the Rise Appendix: Default Study Methodology Related Research
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Default Study:
A Changing Market Composition Points To A Lower Corporate Default Rate On The Horizon In Europe
Gradually improving economies and investors' continued appetite for corporate credit in the bond markets on attractive terms is helping to stabilize credit quality for European nonfinancial corporate issuers somewhat. Nonetheless, there is further work to be done in dealing with vulnerable, highly leveraged pre-2008 vintage credits that will maintain pressure on defaults in CLO portfolios. Taking into account the growing proportion of new speculative-grade issuers in our portfolio (that is, those we rate 'BB+' and below), which generally have better credit quality than was previously the case, we anticipate that the overall default rate (including for private companies) could decline to 5.2% by the end of March 2015 from 5.9% at the end of 2013. However, we would likely raise our default expectations if we see signs of overheating in the high-yield market. Overview Eleven corporate issuers defaulted in the fourth quarter of 2013, taking the full-year total to 42. As a result, the speculative-grade default rate declined to 5.9% for the full year from 7.2% in 2012. The default rate by value of defaulted debt dropped sharply in 2013, to 2.7% from 4.3% in 2012. The amount of outstanding debt held by defaulting issuers to which we assign private credit estimates fell in 2013 to 10.4 billion--the lowest annual figure since 2007. We anticipate a steady stream of defaults through the remainder of this year as 2007-2008 vintage CLOs finally exit their reinvestment periods, overleveraged 2006-2008 loan issuers struggle to refinance, and banks prepare their balance sheets ahead of the European Central Bank's Asset Quality Review.
A Steady Stream Of Defaulters

Nonfinancial corporate defaults in Europe continue to percolate through investors' portfolios at a steady rate, as we saw in the fourth quarter of 2013. Looking both at issuers with public credit ratings and those to which we assign private credit estimates, 11 companies defaulted in the fourth quarter, taking the full-year total to 42. This compares with 17 in the fourth quarter of 2012 and 51 for the full year. As a consequence, the speculative-grade default rate for full-year 2013 declined to 5.9% from 7.2% at the end of 2012, and from 6.8% at the end of the third quarter of 2013 (see table 1).
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Default Study: A Changing Market Composition Points To A Lower Corporate Default Rate On The Horizon In Europe
Table 1
European Public And Private Speculative-Grade Defaults 2009-2013 (By Number)*

Private Credit Estimates No. of entities* Q1 2009 Q2 2009 Q32009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 582 574 599 623 616 608 578 556 539 522 516 510 507 478 475 458 441 429 424 392 No. of defaults 26 24 22 15 5 9 7 7 8 5 4 12 7 8 12 15 8 8 5 6 TTM default rate (%) 10.3 13.8 15.9 14.0 10.7 8.4 6.2 5.0 5.8 5.2 4.7 5.7 5.5 6.5 8.2 9.2 9.8 10.0 8.5 6.9 Public Speculative-Grade Ratings No. of entities* 176 170 165 159 163 166 170 174 182 190 212 223 241 259 255 249 256 252 291 320 No. of defaults 4 2 6 4 1 3 1 0 1 1 0 2 3 3 1 2 4 4 2 5 TTM default rate (%) 5.1 6.5 9.7 10.1 8.0 8.4 5.3 2.9 2.7 1.6 0.9 1.8 2.5 3.1 3.5 3.6 3.9 4.4 4.1 4.7 Combined Default rate (%) 9.1 12.1 14.5 13.2 10.2 8.4 6.0 4.5 5.0 4.2 3.6 4.5 4.5 5.3 6.6 7.2 7.6 7.9 6.7
*Number in database at start of period. TTM--Trailing 12 months. Europe--EU-28 + Iceland, Norway, and Switzerland. Source: Standard & Poor's.
Looking at the composition of defaults, there were five defaults on publicly rated companies in the fourth quarter, taking the full-year default total to 15, generating a public speculative-grade default rate of 4.7%. This compares with nine defaults in 2012 for a default rate of 3.6% under our newly revised methodology (see sidebar below for an explanation of our revised methodology for calculating defaults). On the credit estimates side, there were six defaults in the fourth quarter of 2013, resulting in a full-year total of 27 and a 12-month trailing default rate of 6.9% (see chart 1). This is somewhat below the full-year 2012 levels of 42 defaults and our revised 9.2% default rate.
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Our Revised Default Calculation Methodology To improve consistency with our CreditPro default statistics, we've revised the calculation of the denominator we use to derive the default rates in this study. From now on, we will take the initial number of rated nonfinancial speculative-grade corporates and credit estimates in our portfolio at the start of the year rather than take the average over the year. This will mean that the methodology for calculating our 12-month trailing default rate will be consistent with other default data that Standard & Poor's derives from CreditPro using our static pool methodology. The overall effect on the European nonfinancial corporate default rate for 2013 was insignificant because the lower implied default rate for credit estimates (using a higher start-of-year count as the denominator) was almost exactly offset by the higher implied default rate for our rated speculative-grade companies (using a lower start-of-year count as the denominator).
Chart 1
According to our revised methodology, the average European default rate for nonfinancial corporates over the past five years (since the start of 2009) is 7.4%--exactly the same as under our prior average period method. This average rate combines both the heavy, albeit rapidly declining, weight of the private credit estimates pool, where the average
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default rate was 8.5% (versus 9.0% under our previous method) and the 4.6% average default rate for rated corporates (versus 4.3% under our previous method).
The Default Rate By Value Falls Back To Q3 2011 Levels

The combined default rate by value of defaulted debt (see table 2) also declined in 2013, to 2.7% of the total outstanding balance, well below the 4.3% rate in 2012 and the annual average of 4.7% since the start of 2008. The amount of outstanding debt held by defaulting private credit estimate issuers fell in 2013 to 10.4 billion--the lowest annual figure since 2007 and well below the average 18.4 billion we've witnessed over the past six years. At the same time, we anticipate that there will be a steady stream of defaults throughout 2014 as 2007-2008 vintage CLOs finally exit their reinvestment periods, overleveraged 2006-2008 LBO loan issuers struggle to refinance maturing debt, and banks window-dress their balance sheets ahead of the European Central Bank's (ECB's) Asset Quality Review later in the year. These defaults may include some larger companies, since we maintain private credit estimates at the 'ccc/cc' level on seven issuers, each with outstanding debt liabilities that exceed 1 billion.
Table 2
European Public And Private Speculative-Grade Default (By Value)*

Private Credit Estimates No. of defaults Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 1 5 6 23 26 24 22 15 5 9 7 7 8 5 4 12 7 8 12 15 8 8 Value (bil. ) 3.02 0.71 0.97 7.45 14.21 11.98 9.27 5.40 0.69 9.25 2.79 1.39 2.86 1.77 5.96 4.92 4.65 1.37 5.52 6.12 1.67 5.19 TTM default rate (%) ---3.4 6.6 9.8 12.1 11.5 8.2 7.9 6.2 5.2 6.6 3.6 4.9 6.3 7.1 6.4 6.6 7.2 6.2 8.5 Public Speculative-Grade Ratings No. of defaults 0 0 1 4 4 2 6 4 1 3 1 0 1 1 0 2 3 3 1 2 4 4 Value (bil. ) 0.00 0.00 0.44 19.98 3.35 8.23 5.10 4.89 0.00 2.47 2.17 0.00 0.37 0.41 0.00 3.17 10.52 1.99 0.46 4.14 4.37 3.91 TTM default rate (%) ---5.6 6.5 8.8 10.1 5.9 5.0 3.4 2.6 1.2 1.3 0.8 0.2 0.9 2.8 2.8 2.6 3.1 1.9 2.1 Combined TTM default rate (%) ---4.5 6.6 9.3 11.1 8.7 6.5 5.5 4.2 2.9 3.4 1.9 2.0 2.9 4.2 4.0 3.8 4.3 3.1 3.8
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Table 2
European Public And Private Speculative-Grade Default (By Value)* (cont.)

Q3 2013 Q4 2013 5 6 2.22 1.30 8.0 5.7 2 5 1.95 3.63 2.2 1.9 3.5 2.7
*Europe = EU-28 + Iceland, Norway, and Switzerland. TTM--Trailing 12 months. Source: Standard & Poor's.
The Portfolio Shifts Toward Speculative-Grade Ratings

While we anticipate that the overall default rate will remain above the historical average of 4.7% over the next two years, the changing composition of the leverage finance market toward higher quality and more recently rated issuers should, in our view, enable the default rate to fall back toward more normal levels (all else being equal). Consequently the proportion of issuers in our combined portfolio originated since 2009 has risen to 62% (by number), with the majority of our new ratings centered on companies issuing debt in the high-yield market. This mainly reflects nonfinancial corporate issuers diversifying their term funding away from their relationship banks to the debt capital markets; the liquidity and relatively low cost of bond financing; and the hiatus in the CLO structured finance market in recent years (although that market is now picking up again). The result is that the proportion of our combined portfolio that we view as 'CCC/cc' has fallen below 10.0% to 9.5% for the first time since the second half of 2009.
The Default Rate Will Likely Fall To 5.2% By March 2015

This shift in the portfolio toward newer and higher-quality issuers from a credit perspective (see chart 2), coupled with our expectation that the economic environment will most likely continue to improve gradually over the next year or two, suggests that the underlying default rate could move lower. Our latest trailing 12-month default forecast for March 2015 reflects this view (see table 3).
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Chart 2
Table 3
European Speculative-Grade Default Projections To March 2015

One-Year Default Assumptions For Ratings/Credit Estimates Ratings/Credit Estimates Base case (% per year) >B+ B+ B BCCC/CC Default rates Percentage No. of defaults Source: Standard & Poor's. 3.6 15 7.9 20 5.2 35 4.7 20 10.0 26 6.7 46 Default Assumptions Downside
Public ratings Credit estimates Combined Public ratings Credit estimates Combined 0.6 1.9 3.8 6.0 21.7 0.6 2.1 4.3 6.7 23.4 0.8 2.4 5.1 8.2 26.9 0.9 2.6 5.5 8.9 28.6
Our base-case assessment takes into account the following assumptions:
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Default Study: A Changing Market Composition Points To A Lower Corporate Default Rate On The Horizon In Europe An ongoing gradual economic improvement in the eurozone (European Economic and Monetary Union), with Germany and the U.K. taking the lead and the periphery and France following in their trail, with a lag. Our expectation that the ECB official policy rates are unlikely to increase until late 2015 at the earliest, while the U.K. might initiate modest increases earlier in 2015. This would provide significant support for companies' debt service capacity. While the cost of corporate financing remains an issue across the eurozone, the combination of an improving liquidity position for the major banks and the increasing private nonbank provision of debt finance will continue to erode the higher risk premiums required for peripheral borrowers. Modest signs of improving liquidity in the loan market. Banks' underwriting capacity is benefiting from the return of the primary CLO market, older CLOs exiting reinvestment now being past their peak, as well as growing confidence in the broader economic environment and the banks' improving capital positions. As a consequence, after applying slightly lower one-year default stress assumptions than for our previous default forecast in December 2013(see "European Defaults Remain Elevated As Legacy Transactions Take Their Toll," published Dec. 10, 2013, on RatingsDirect) and reflecting the shifting weight in our speculative-grade portfolio away from private credit estimates, we envisage that the combined default rate will fall to 5.2% by the end of March 2015, from our previous baseline forecast of 6.0% for year-end 2014. In a more pessimistic downside scenario--which might correspond with growing issuance from more aggressively financed issuers or smaller businesses with weaker business risk profiles, or with a weaker, more disinflationary economic environment--we could envisage the default rate remaining elevated, at about 6.7%.
Business Services, Retail, And Transportation Head The Default Tally

In 2013, business services (mostly smaller businesses) and media and entertainment (boosted by Codere defaulting publicly three times in the space of six months) continued to suffer defaults at an above-average rate (see table 4). The retail and restaurant segment, which we also view as an asset-light, highly cyclical sector, saw the default rate pick up over the year, especially businesses in the periphery and France. The weak and highly segmented shipping industry, along with the logistics industry, contributed the most to transportation defaults.
Table 4
European Speculative-Grade Corporate Default Rate By Industry Sector (2008-2013)

Default rate* (%) (No. of companies) Business services Media and entertainment Retail/restaurants Transportation Utilities Forest products Homebuilders/real estate Automotive Telecommunications Health care 48 106 75 40 15 32 48 34 36 61 2008 1.4 4.5 5.1 4.9 0.0 0.0 11.3 9.5 3.3 3.2 2009 13.3 14.3 22.7 7.5 0.0 0.0 22.6 23.7 11.5 3.3 2010 4.5 6.7 2.6 4.8 0.0 0.0 0.0 2.5 8.0 3.2 2011 1.7 6.4 7.0 7.4 0.0 0.0 3.9 4.9 3.3 3.3 2012 16.4 8.5 4.0 10.5 0.0 0.0 2.0 2.6 3.2 5.0 2013 12.6 10.4 8.1 7.6 6.9 6.3 6.3 6.0 5.6 5.0
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Table 4
European Speculative-Grade Corporate Default Rate By Industry Sector (2008-2013) (cont.)

Chemicals, packaging, environmental Oil and gas Capital goods Consumer products Technology 44 23 43 52 21 10.6 0.0 1.7 7.1 5.0 19.0 0.0 10.0 13.0 22.2 1.7 4.5 3.8 1.6 9.5 3.9 0.0 7.0 6.4 0.0 13.5 4.1 4.7 13.2 4.7 4.5 4.4 0.0 0.0 0.0
*Data combines rated entities and private credit estimates. Europe = EU-28 + Iceland, Norway, and Switzerland. Source: Standard & Poor's.
However, it's revealing to compare the recent default experience with issuer characteristics in the high-yield market since the start of 2009, when activity in that market started to pick up. Prior to 2009, the most indebted companies looking to raise financing in the high-yield market were in the telecommunications, metals and mining, and paper and forest products sectors. In our view, this reflected a variety of factors, not least the capital intensity of the respective sectors, their degree of industry concentration, and the risk that high debt exposure represented to relationship banks. Since 2009, the picture has evolved. The three sectors with the most outstanding debt held by newly rated speculative-grade companies are now retail and restaurants, media and entertainment, and transportation, and these are three of the four sectors that experienced the highest default rates in 2013. Much of the new issuance for companies in these sectors represents loan-for-bond refinancing, which raises some interesting questions: What are the relationship banks doing to encourage these companies to diversify their funding? And are investors' risk assessments properly accounting for the default experience at the sector level? Of course, investors would need to consider many other elements to make a proper judgment of risk, including the security package and other investor protections provided in the various financing documents.
The Credit Quality Of U.K. Companies May Be A Cause For Concern

The 2013 default experience broadly reflects the economic trends playing out at the country level (see chart 3). Defaults in both Germany and the U.K., for instance, have slipped lower to well below average in 2013, while they remain well above average in the periphery. The default rate in France remains significant even though it has fallen from an elevated 11.1% at the end of 2012 to 7.0% at year-end 2013, with eight defaults occurring in 2013, compared with 14 in 2012. In our view, this relatively high level partly reflects the relative underperformance of the French economy and the reticence of senior lenders in France to recognize the structural vulnerability of many overleveraged companies in France in recent years.
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Chart 3
However, the default experience to date likely masks the location of future weaknesses, from our perspective. First, notwithstanding the high level of non-performing loans monitored by the Bank of Italy and the Bank of Spain, the number of Italian and Spanish speculative-grade corporates that we track is low representing just over 11% of our portfolio, of which about one-third have credit quality of 'B-' or lower. Of greater concern to us is the credit quality of U.K. speculative-grade companies that comprise almost 23% of our portfolio, of which 8% have highly leveraged financial risk profiles in the 'B-/CCC' categories. Most of them are LBOs originated prior to the financial crisis. By comparison, the ratings distribution for French and German companies poses less of a prospective credit concern because we assess a little less than 5% of companies in both of these countries at the 'B-/CCC' level.
Recovery Rates For Senior Secured Debt Are On the Rise

Tracking post-default recoveries over the most recent cycle (since 2007) reveals that average recovery rates for senior secured debt have improved materially since 2011. This reflects the upturn in the economy and improved prospects for companies facing restructuring or exiting bankruptcy as the capital markets began to reopen. The pattern has been similar to that in the U.S., although the improvement there began slightly earlier, toward the end of 2010, with 2009 reflecting the lowest point for recoveries.
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For more information on recovery rates, see table 5 and observations in our recent report titled "Standard & Poor's European Recovery Rating Performance--A Six Year Study," published Feb. 25, 2014. This study analyses the recoveries for a (somewhat limited) sample of 27 European rated companies that have emerged from default since 2007 where recovery ratings had been assigned to the various debt instruments.
Table 5
Mean European Corporate Recoveries By Year Of Exit

--No. Of Companies-Senior secured bank debt 90%-100% -90%-100% 50%-60% 80%-90% ---Mean Percentage Recovery-Senior secured bonds 20%-30% -30%-40% 20%-30% 50%-60% 50%-60% --
Year 2007 2008 2009 2010 2011 2012 2013 Total Weighted average*
Exited 2 0 11 6 3 4 1 27
Unsecured debt --40%-50% 30%-40% 0%-10% 70%-80%
Subordinated debt --10%-20% 0%-10% 0%-10% --
83%
37%
36%
11%
*Weighted average by number of companies, using mid-point of mean recovery range. Source: Standard & Poor's.
Appendix: Default Study Methodology

Our default study covers the broadest investable universe for European institutional investors by including leveraged loans and high-yield bonds. Our universe comprises speculative-grade nonfinancial companies (that is, those with a public rating of 'BB+' or private credit estimate of 'bb+' or lower) domiciled in Europe (EU-28 plus Iceland, Norway, and Switzerland). The calculation of the denominator used to determine the default rates is now the number of rated nonfinancial corporates and private credit estimates in our static pool at the start of the year rather than the average over the year. This methodology is slightly different to that applied by Standard & Poor's Global Fixed Income Research (GFIR). GFIR tracks corporate defaults including financial institutions and insurance companies but only for rated companies (not credit estimates).
Standard & Poor's definition of default

For publicly rated companies (see chart 4), we record a default when we see that a company fails to make a scheduled payment of principal or interest on any financial obligation, files for bankruptcy, or completes the restructuring of a financial obligation involving what we consider to be a distressed exchange offer. We recognize defaults on the date that we assign a 'D' (Default) or 'SD' (Selective Default) classification to the company.
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Chart 4
For companies with a private credit estimate (see chart 5), the process is not quite so straightforward. Where a coupon or principal payment is not paid on time we then consider that the default occurs on that date. However, in the case of a debt restructuring, we recognize that a default has occurred either on the date a restructuring plan is implemented (if payments remain current) or on the date of the first missed payment, whichever occurs first.
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Chart 5
Due to the time lag involved in receiving information relating to restructurings for private unrated companies, or to companies that defaulted after their ratings were withdrawn, it is not uncommon to revise default rates over time.
Related Research
The articles listed below are available on RatingsDirect unless otherwise stated.
Standard & Poor's European Recovery Rating Performance--A Six Year Study, Feb. 25, 2014 European Defaults Remain Elevated As Legacy Transactions Take Their Toll, Dec. 10, 2013 Proceed With Caution: European Corporate Credit Outlook 2014, Dec. 11, 2013. For more details, access https://ratings.standardandpoors.com/economic-research/europe-middle-east-and-africa/The-Outlook-For-Europe-in-2014.htm Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.
Additional Contact:
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Industrial Ratings Europe; Corporate_Admin_London@standardandpoors.com
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Default Study:

MARCH 10, 2014 1

A Steady Stream Of Defaulters

MARCH 10, 2014 2

European Public And Private Speculative-Grade Defaults 2009-2013 (By Number)*

MARCH 10, 2014 3

MARCH 10, 2014 4

The Default Rate By Value Falls Back To Q3 2011 Levels

European Public And Private Speculative-Grade Default (By Value)*

MARCH 10, 2014 5

European Public And Private Speculative-Grade Default (By Value)* (cont.)

The Portfolio Shifts Toward Speculative-Grade Ratings

The Default Rate Will Likely Fall To 5.2% By March 2015

MARCH 10, 2014 6

European Speculative-Grade Default Projections To March 2015

Our base-case assessment takes into account the following assumptions:

MARCH 10, 2014 7

Business Services, Retail, And Transportation Head The Default Tally

European Speculative-Grade Corporate Default Rate By Industry Sector (2008-2013)

MARCH 10, 2014 8

European Speculative-Grade Corporate Default Rate By Industry Sector (2008-2013) (cont.)

The Credit Quality Of U.K. Companies May Be A Cause For Concern

MARCH 10, 2014 9

Recovery Rates For Senior Secured Debt Are On the Rise

MARCH 10, 2014 10

Mean European Corporate Recoveries By Year Of Exit

Unsecured debt --40%-50% 30%-40% 0%-10% 70%-80%

Subordinated debt --10%-20% 0%-10% 0%-10% --

Appendix: Default Study Methodology

Standard & Poor's definition of default

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Industrial Ratings Europe; Corporate_Admin_London@standardandpoors.com

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