Economic weakness, higher rates could push defaults to 2020 levels
Default risk for UK corporate borrowers will continue to run higher into 2024 according to recent data from Moody’s Analytics, underscoring the need for active credit risk monitoring and management. As of November 1, the average one-year expected probability of default (PD) for private and public UK companies reached 2.9% and 3.1%, respectively.
Exhibit 1 shows the average one-year, forward-looking PDs for public (light blue) and private (dark blue) UK companies, measured monthly. For private firms, the average expected probability of default is 30% higher than the post-pandemic low reached in 2022, and for public firms it has nearly doubled over the same time period. Default risk measures for both public and private companies are running nearly 35% above their post-GFC average of 2.2%.
Higher borrowing costs, together with uncertainty about the outlook for the UK economy, and its implications for corporate earnings, supports the deteriorating credit risk picture over the next year.
Moody’s Analytics’ baseline economic scenario for the UK assumes that economic growth will continue to be below potential for some time. Annual real GDP growth for the UK is forecasted to be an anemic 0.65% in 2023, weakening further to 0.34% in 2024 under the baseline scenario. The scenario also anticipates that the BoE will not implement further rate hikes, but that rate cuts would be expected to start only in mid-2024, while the return to the long-run equilibrium rate of 2% is expected to be much more gradual.1
The higher-for-longer rates outlook will continue to weigh heavily on corporate borrowers as the cumulative effect of the BoE’s 14 consecutive rates increases works its way through the economy. The Bank of England’s policy response to combat the highest inflation in decades has rapidly pushed the bank rate from a record low of 0.1% in November 2021 to the current 5.25% level. In its August Bank Overground blog2 post, the BoE warned that UK companies will come under increasing risk of default as they grapple with higher debt servicing stress as a result of higher borrowing costs, with the proportion of firms with low interest coverage ratios projected to increase from 45% in 2022 to 50% by the end of 2023.
The worsening credit environment is already resulting in higher debt defaults. The realized trailing 12-month default rate for UK companies rated by Moody’s Investors Service has risen sharply, from 0.2% in September 2022 to 1.5% as of October 2023 (the red line in Exhibit 1). The trend is also apparent in government statistics. The UK Insolvency Service recently reported that between July 1 and September 30 there were 6,208 registered company insolvencies in England and Wales, the highest level since the GFC according to the agency.3
Moody’s Analytics’ forward-looking probability of default measures have historically led changes in actual corporate default rates by about one year. This relationship is evident in Exhibit 1, where the blue lines, the average expected PDs for public and private firms, rise and peak about a year before the red line, the actual trailing 12-month default rate for all Moody’s-rated UK firms.4 The increase in the average expected PDs since the end of 2021 suggests that the realized default rate for Moody’s-rated UK companies could reach 3.1% by the fourth quarter of 2024, rivaling the 3% peak default rate following the Covid pandemic economic shock in 2020. In the event that we do see the pace of defaults reach that level, it would be the highest default rate for UK Moody’s-rated companies since the 4.4% annual default rate recorded in 2009 during the height of the GFC (and during which more that 10% of below investment-grade rated firms defaulted).
Tight monetary and refinancing conditions are resulting in rising default risk across industry sectors. Exhibit 2 shows how the average one-year expected PDs for UK public companies have changed over the 12 months ending Q3 2023, ranked from highest to lowest risk (PD) level. Fifteen of the 21 industry sectors have experienced an increase in the average one-year risk of default in the last 12 months, with 9 sectors posting increases of 30% or more in their expected average probability of default. Energy, discretionary consumer, and capital cost-sensitive sectors have seen the greatest increases in credit risk.
Not only have CRE, capital cost-sensitive, and discretionary consumer sectors experienced the highest increase in forward-looking default risk (Exhibit 2), the same sectors have also seen the highest number of actual defaults in 2023. So far in 2023 2,749 UK companies (public and private) have experienced a credit event (missed payment, insolvency, administration).5 Exhibit 3 shows the distribution of actual UK company defaults in 2023 through October by industry sector.
As credit stress intensifies, identifying companies most at-risk is critical
The rise in default risk for UK companies has brought renewed emphasis on the need to actively manage credit risk. In a period of heightened credit stress, it can be particularly difficult to spot potential problem borrowers as many, if not, most companies are impacted by the more difficult operating environment. When we see the average risk of default for an industry sector increase sharply, as it has for the construction and real estate sector, for example, identifying exactly which firms in the stressed sector are most likely to experience a credit event becomes critical.
Moody’s Analytics’ Early Warning System (EWS) was designed to do just that. The EWS uses two key measures to identify companies as low, medium, high, or severe risk over the next 12 months. The two measures are (1) whether a company’s forward-looking PD measure is above an appropriate sector early warning trigger level; and (2) the change in the PD-implied rating. Moody’s Analytics research has shown that public companies with high early warning signals are 25 times more likely to default over the next year than firms with low early warning signals.
As of November 2023, Moody’s Analytics’ Early Warning System shows that of the 1,387 public UK companies, 320 – nearly one in four – are flagged as high or severe risk compared to their industry sector peers. In Exhibit 4 the orange and red circles represent these most at-risk companies, with the size of the circles indicating the relative sizes (in terms of asset value) of the companies.
The data in Exhibit 4 suggests that company size and early warning at-risk status are correlated in the current macro-credit climate: higher borrowing costs and weak economic fundamentals have contributed to causing smaller public companies to be more likely categorized as high or severe risk. Larger firms have proved to be more resilient to the challenging macro-credit environment, as evidenced by the relatively higher number of firms in the low EWS risk category with larger, green circles.
Exhibit 5 sheds more light on which UK corporate sectors are triggering more early warning alerts. The graph is sorted by industry sectors showing the highest percentage of companies with high or severe Early Warning System signals. Many of the industry sectors whose average one-year expected default risk have increased the most over the past year also show the highest percentage of firms with high or severe early warning signals. Energy, travel/leisure, equipment, and transportation – cyclically sensitive sectors – show a relatively high percentage of risks.
The necessity and value of an effective early warning system becomes clear when we look at the example of Wilko Limited, which fell into administration on 10 August, 2023. Wilko Limited, the venerable 93-year-old high-street retailer chain, is a private, unrated, family-owned business. At the time of its default, the company was estimated to owe £548 million to unsecured creditors, including its own pension scheme and its suppliers.6 PricewaterhouseCoopers, Wilko’s administrator, estimated that unsecured creditors stood to recovery between just 4% and 8% on the pound of their claims. With no traded equity or debt, and no public ratings, monitoring exposure to a company like Wilko would seem to be a nearly impossible challenge.
Moody’s Analytics’ EWS, however, flagged Wilko as an elevated risk of default in January 2022. Its one-year expected PD jumped from 0.38% at the end of 2021 to 5.2% in January 2022 after the company reported a £36.8 million pre-tax loss from a profit of £4.4 million the previous year. At the same time, the jump in its expected PD measure breached the early warning trigger level for its industry sector. On its own, a 5.2% probability of default over a one-year time horizon may not appear to be a signal of imminent risk. A 5% one-year PD maps roughly to a single-B level of risk on Moody’s ratings scale – not an insignificant level of risk, but seemingly not an urgent threat. Given the uncertainty around Wilko’s financial situation in 2022 and early 2023, when it sought to raise capital to keep it afloat, creditors must have both feared and hoped for the company’s future.
It is precisely in such situations that an effective early warning system is needed. By making relative comparisons with appropriate peer groups in industry sectors (in a given country), Moody’s Analytics’ Early Warning System helps identify which companies are most at risk, even when, in absolute terms, it may not be clear what risk measures may be implying about future credit risk. Between August and September 2023, Wilko’s PD jumped from 6.1% to 35%7 as the company collapsed into administration.
Higher default risk, no recession required
The rising trend in Moody’s Analytics’ probabilities of default for UK companies shows that regardless of whether the UK economy technically enters a recession in 2024 or not, the level of credit stress may be as severe as that experienced during the peak of the Covid pandemic. If UK economy underperforms, Moody’s Analytics’ recession scenario for the UK forecasts that real GDP growth in 2024 would be negative for all four quarters, for a -2.6% growth rate for the year. Under such a scenario, default rates would likely rise to levels consistent with historical recessions, in the neighborhood of 4% for all UK companies, and around 10% for below investment-grade firms.
Cyclical industry sectors, discretionary consumer, and capital cost-sensitive sectors are most at-risk over the next year. Moody’s Analytics’ Early Warning System confirms that not only are those industry sectors seeing relatively high year-over-year changes in credit risk, but they also represent sectors with the highest concentrations of companies that have breached early warning trigger levels. By focusing on those companies, investors and lenders can potentially take proactive measures to mitigate any future credit losses, as the example of Wilko Limited shows.
1 Moody’s Analytics alternative economic scenarios are available through www.economy.com to subscribers of the service.
4 Our projection of the Moody’s UK corporate default rate is derived from a regression of the historical Moody’s UK corporate default rate on the 12-month lagged average expected PD. It is not a forecast of the default rate from the ratings agency itself.
5 The 2,749 UK company defaults include both public and private, rated and unrated debt defaulters.
6 Onita, L. (2023, September 29). Wilko collapsed owing unsecured creditors almost £550mn, Financial Times.
7 35% is the maximum forward-looking probability of default for a UK private company in Moody’s Analytics EDF-X platform.