COVID-19 And The Credit Cycle

Abstract

The COVID-19 health crisis has dramatically affected just about every aspect of the economy, including the transition from the record long benign credit cycle to a stressed one, with still uncertain dimensions. This paper seeks to assess the credit climate from just before the unexpected global health crisis catalyst to its immediate and extended impact and the performance of several key indicators of the nature of credit cycles - - default and recovery rates on high yield bonds that we expect to default over the next 12 months, and beyond, yield spreads and distress ratios, and liquidity. Our focus is primarily on the non-financial corporate debt market in the U.S. which reached a record percentage of GDP at the end of 2019 as firms increased their debt to take advantage of record low interest rates and investor appetite grew for higher promised yields on risky fixed income assets. We also examine the leverage loan and CLO markets as well as the increasingly large and important BBB tranche of the corporate bond market. Specifically, the latter’s vulnerability to downgrades over the expected downturn in the real economy and this vulnerability’s potential impact on expected default rates by “crowding-out” other firms’ very low quality firm debt, some of them “zombies”. Using Z-Scores for a sample of BBB companies between 2007 and 2019, we analyze this largest component of the corporate bond market to provide some evidence on the controversial debate as to whether there has been rating-inflation or perhaps, persistent over-valuation of the non-financial corporate debt market since the last financial crisis.