Estimating the Impact of COVID-19 on Corporate Default Risk Estimating the Impact of COVID-19 on Corporate

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  • Working Paper

    Estimating the Impact of COVID-19 on Corporate Default Risk

    Jonathan William Welburn, Aaron Strong

    RAND Social and Economic Well-Being

    WR-A173-2 June 2020

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  • Estimating the Impact of COVID-19 on Corporate Default Risk

    Jonathan W. Welburn, Aaron Strong

    Draft: 6/16/2020


    The COVID-19 global pandemic has resulted in a fast-moving health crisis with

    significant uncertainty. Policy makers have responded by imposing social

    distancing policies (non-pharmaceutical interventions) which close schools, bars,

    and restaurants, close non-essential business, restrict movement, and impose

    quarantines. Under the weight of significant business interruptions, reductions in

    both supply and demand, and supply chain disruptions the health crisis has given

    way to deep economic contraction. The confluence of sharp economic losses and

    historic levels of corporate debt risk producing a financial crisis on top of the health

    crisis. We build on the work of Vardavas et al. (2020) and Strong and Welburn

    (2020), who estimate the health and economic impacts of COVID-19 under a set

    of social distancing scenarios, to estimate the potential for firm exits. We use a

    structural model of financial distress based on Merton's distance to default to

    estimate the likelihood of firm defaults conditional on losses in aggregate income.

    Using the Vardavas et al. (2020) set of scenarios and estimations of reduced income,

    we estimate average firm default probabilities over a large set of US listed firms.

    We find that the crisis coincides with exceptional risk of corporate default. Under

    modest levels of social distancing and economic losses, we estimate high levels of

    average corporate default risk. As social distancing measures and economic

    contractions persist, levels of corporate default risk exceed those of the 2008

    financial crisis. Under the harshest scenarios of prolonged strict interventions, we

    estimate exceptional levels of corporate default risk ranging from to double to triple

    those witness during the 2008 financial crisis. While unmodeled, recent credit

    market interventions may thwart the worst of the default risk scenarios that we

    estimate by extending credit access to firms on the brink of insolvency.

    Acknowledgments: We would like to thank Tyna Eloundou, Jeanne Ringel, Krishna

    Kumar, and Howard Shatz for their useful support, comments, and feedback. We would

    also like to than Anita Chandra and Peter Hussey for their support of this work through

    RAND 's Social Economic and Well-Being and Health Care research divisions.

  • 0







    1987 1992 1997 2002 2007 2012 2017

    Total default rate (%) Investment-grade default rate Speculative-grade default rate

  • 𝑉

    𝑑𝑉 = 𝜇𝑉𝑑𝑡 + 𝜎 𝑉𝑑𝑊

    𝜇 𝜎

    𝐸 𝐹 𝑟

    𝐸 = 𝑉𝒩(𝑑 ) − 𝑒( )𝐹𝒩(𝑑 )

  • 𝑑 = ln 𝑉 𝐹⁄ + (𝑟 + 0.5𝜎 )𝑇

    𝜎 √𝑇 , 𝑑 = 𝑑 − 𝜎 √𝑇

    𝑇 𝑇 = 1

    𝜎 = 𝑉



    𝛿𝑉 𝜎


    𝜎 = 𝑉

    𝐸 𝒩(𝑑 )𝜎


    𝜎 = 𝜎 𝐸

    𝐸 + 𝐹 + (0.05 + 0.25 ∗ 𝜎 )


    𝐸 + 𝐹

    𝜎 𝐸 𝐹


    𝐷𝐷 = ln(𝑉 𝐹⁄ ) + (𝜇 + 0.5𝜎 )𝑇

    𝜎 √𝑇 .

    𝜋 𝑇

  • 𝜋 ≡ 𝑃(def | 𝐸, 𝐹, 𝜎 ) = 𝒩(−𝐷𝐷 ) = 𝒩 − ln[(𝐸 + 𝐹) 𝐹⁄ ] + (𝑟 + 0.5𝜎 )𝑇

    𝜎 √𝑇 .



    𝜓 = 𝐿 𝑌 = 𝐿

    𝑌 , 𝜓 ∈ [0,1]

    𝐿 𝐿

    𝑌 𝑌


    𝑁 𝑁

    𝑁 = 𝑁 − 𝜓 ∗ Δ ∗ 𝐺




  • 𝐹 = 𝐹 + 𝜓 ∗ Δ ∗ 𝐺.


    𝑉′ = 𝑁𝐼 + 𝛿 (1 + 𝑔)𝑁𝐼 = 𝑉 − (𝑁𝐼 − 𝑁𝐼 )

    𝛿 𝑔



    𝐸 = 𝑉 − 𝐿 + 𝑇𝐴 = 𝐸 − (𝑁𝐼 − 𝑁𝐼 ).

    𝜎 = 𝜎 𝐸

    𝐸 + 𝐹 + (0.05 + 0.25 ∗ 𝜎 )


    𝐸 + 𝐹


    𝜎 .

    𝜋 = 𝒩 − ln[(𝐸′ + 𝐹′) 𝐹⁄ ] + 𝑟 + 0.5𝜎 𝑇

    𝜎 √𝑇


    𝑇 = 1

  • 4%






    1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

    de fa

    ul t p

    ro ba

    bi lit


    duration, weeks

  • 2B





    4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

    sce na


    duration, weeks

    0.0%-2.0% 2.0%-4.0% 4.0%-6.0% 6.0%-8.0% 8.0%-10.0%

  • public health and the economy, we find that resulting large losses in output may further

    exacerbate economic shocks through significant risk of corporate default and firm exit.

    The COVID-19 pandemic hits corporate debt markets which would otherwise be facing

    large headwinds from historic levels of corporate debt. Significant income losses and high

    preexisting debt levels result in high risk levels where even the most modest of social

    distancing scenarios result in high risk levels. However, as the economic consequences

    become more burdensome, either as a result of severe social distancing or long crisis

    durations, our estimated average likelihood of default correspond to default rates which

    exceed the spike in corporate default seen during the 2008 crisis.

    This analysis, of course, comes with limitations. First, we estimate default risk for

    listed firms and thereby do not capture risks to many small businesses which may be

    higher. Second, we take the approach of using a structural model to estimate default

    likelihoods conditional on estimated losses. As estimations compound, uncertainty grows.

    This effort aims to bound default risk, all things equal, and in the absence of policy.

    However, the extraordinary measures - both monetary and fiscal - will likely lessen the

    impact of the COVID-19 crisis in the near term making our estimates more of an upper

    bound in reality.

    Policy interventions alter the landscape of default risk. Following the emergency

    reduction in its benchmark interest rate on March 1, 2020, the U.S. Federal Reserve has

    provided trillions of dollars in stimulus to support credit markets across assets classes.

    While the Fed began purchasing commercial paper and investment grade commercial debt,

    providing support to fund daily corporate expenses, on March 17th , they extended their

    support to midsize corporations on March 23rd , expanded support on March 23rd , and

    expanded commercial paper purchases to sub-investment grade debt on April 9th (Julia­

    Ambra and Wyatt, 2020). This, in combination with large stimulus efforts of the CARES

    Act and the coronavirus relief program of the Small Business Administration, pr