The Outlook for the Corporate Credit Default Cycle

Goldman Sachs identified three sequential risks to corporate credit markets in early March:

• Risk 1: Rising financial distress on corporate balance sheets leading to higher defaults and accelerated downgrades, particularly for bonds transitioning from investment grade to high yield in Asia.
• Risk 2 (Most Severe): An abrupt contraction in credit availability for creditworthy companies, creating a potential full-blown credit crunch.
• Risk 3: Severe impairment in secondary market liquidity, challenging investors' ability to transfer and price risk.

Fed intervention status as of late March/April:

• The second risk (credit crunch) and third risk (liquidity impairment) materialized rapidly within the first two weeks of March but have "materially abated" following the Fed's launch of corporate credit facilities.
• The first risk (rising financial distress) remains intact due to the depth of the recession and cyclical challenges facing lower-rated companies.
• The Fed's March 23rd announcement is identified as a key inflection point for both credit markets and broader risk assets.

Scope and impact of Federal Reserve actions:

• The Fed assumed an explicit role as a "lender of last resort" to non-financial corporations and an implicit role as a "market liquidity provider of last resort" to investors.
• While the Fed's facility size and scope were more modest than those of the ECB, Bank of England, or Bank of Japan, Goldman Sachs research suggests the "announcement effect" was more powerful than with other central banks.
• Dollar investment grade new issue volumes surged over 85% year-to-date compared to 2019 levels.
• Secondary market liquidity conditions normalized over the past three to four weeks after deteriorating beyond levels seen at the height of the global financial crisis.

Forward-looking default forecasts:

• Goldman Sachs maintains a forecast for a 13% annual high yield default rate by the end of the year, a figure consistent with historical recession averages.
• The forecast remains unchanged from pre-Fed intervention levels because earnings pressure and balance sheet deterioration will continue to incentivize defaults despite improved refinancing access.
• The rebound in primary market activity prevents an unprecedented spike in high yield defaults but does not eliminate the forward outlook for gradual default increases.

Nature and composition of future defaults:

• The majority of defaults are expected to be strategic (proactive restructurings) rather than forced liquidations, reflecting management recognition of unsustainable debt dynamics.
• Historical data indicates corporate liquidations are rare; most defaults result in Chapter 11 (in-court) or distressed exchanges (out-of-court) with companies typically emerging stronger within 12 to 24 months.
• Analysts will closely monitor for an unusual increase in Chapter 7 liquidation cases, which would signal permanent economic damage; no such evidence currently exists.

Sector rotation and investment outlook:

• Defensive sectors have outperformed cyclical sectors since the onset of the crisis; a recovery is anticipated to drive rotation back into cyclical areas as the economy reopens.
• Credit impact is categorized into three groups: commodities-related (oil, gas, metals), direct disruption sectors (retail, hotels, gaming), and indirect disruption sectors (financials, healthcare, tech).
• High conviction exists for a recovery in the energy sector for high-quality issuers in both investment grade and high yield, driven by declining supply and increasing demand as the economy reopens.