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

Abstract

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

2

4

6

8

10

12

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

𝐸

𝛿𝐸

𝛿𝑉𝜎

𝜎

𝜎 =𝑉

𝐸𝒩(𝑑 )𝜎

𝜎

𝜎 = 𝜎𝐸

𝐸 + 𝐹+ (0.05 + 0.25 ∗ 𝜎 )

𝐹

𝐸 + 𝐹

𝜎 𝐸 𝐹

𝐷𝐷

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.

𝜋

𝜓

𝜓 = 𝐿𝑌 = 𝐿

𝑌, 𝜓 ∈ [0,1]

𝐿 𝐿

𝑌 𝑌

𝐺

𝑁 𝑁

𝑁 = 𝑁 − 𝜓 ∗ Δ ∗ 𝐺

Δ

𝐹

𝐹

𝐹 = 𝐹 + 𝜓 ∗ Δ ∗ 𝐺.

𝑉

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

𝛿 𝑔

Δ

𝐸

𝐸 = 𝑉 − 𝐿 + 𝑇𝐴 = 𝐸 − (𝑁𝐼 − 𝑁𝐼 ).

𝜎 = 𝜎𝐸

𝐸 + 𝐹+ (0.05 + 0.25 ∗ 𝜎 )

𝐹

𝐸 + 𝐹

𝜎

𝜎 .

𝜋 = 𝒩 −ln[(𝐸′ + 𝐹′) 𝐹⁄ ] + 𝑟 + 0.5𝜎 𝑇

𝜎 √𝑇

𝑟

𝑇 = 1

4%

6%

8%

10%

12%

14%

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

defa

ult p

roba

bilit

y

duration, weeks

2B

3B

4B

5B

6B

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

scena

rio

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, provide

firms on the brink of insolvency with access to credit over the short and medium term.

While this may not change their financial distress, it may decrease the risk of default

while interventions last.

However, significant uncertainty may persist. High default risk could continue over

the medium to long term as corporations struggle with high debt levels. While our analysis

is not able to fully capture this uncertainty, it provides a concerning estimate of corporate

default risk which, at a minimum, conveys the justification for the extraordinary stimulus

Black, Fischer, and Myron Scholes, "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, Vol. 81, No. 3, 05/01, 1973, pp. 637-654. http://www.jstor.org/stable/1831029 Edgecliffe-Johnson, Andrew, Peggy Hollinger, Joe Rennison, and Robert Smith, "Will the coronavirus trigger a corporate debt crisis?," Financial Times, 2020. https://www.ft.com/content/4455735a-63bc-11ea-b3f3-fe4680ea68b5 Julia-Ambra, Verlaine, and Tristan Wyatt, "Sizing Up the Fed's Historic Coronavirus Crisis Intervention; While market strain triggered by pandemic has eased, stresses remain," Wall Street Journal (Online), 04/09/ 2020 Apr 09, 2020. https://search.proquest.com/docview/2387817341?accountid=25333 http://aa3rw9le2f.search.serialssolutions.com/directLink?&atitle=Sizing+Up+the+Fed%27s+Hist

oric+Coronavirus+Crisis+Intervention%3B+While+market+strain+triggered+by+pandemic+has+eased%2C+stresses+remain&author=Julia-Ambra+Verlaine%3BWyatt%2C+Tristan&issn=&title=Wall+Street+Journal+%28Online%29&volume=&issue=&date=2020-04-09&spage=&id=doi:&sid=ProQ_ss&genre=article

Kraemer, Nick W, "Default, Transition, and Recovery: A Double-Digit U.S. Default Rate Could Be On The Horizon," 2019. https://www.spglobal.com/ratings/en/research/articles/191002-default-transition-and-recovery-a-double-digit-u-s-default-rate-could-be-on-the-horizon-11165582 Merton, Robert C., "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Vol. 3, No. 1–2, 1//, 1976, pp. 125-144. As of 1976/3//: http://www.sciencedirect.com/science/article/pii/0304405X76900222 Quantopian, As of May, 2020: https://www.quantopian.com S&P Global, 2018 Annual Global Corporate Default And RatingTransition Study, 2018. https://www.spratings.com/documents/20184/774196/2018AnnualGlobalCorporateDefaultAndRatingTransitionStudy.pdf Strong, Aaron, and Jonathan William Welburn, An Estimation of the Economic Costs of Social-Distancing Policies, RR-A173-1, Santa Monica, Calif: RAND Corporation, 2020. https://www.rand.org/pubs/research_reports/RRA173-1.html Vardavas, Raffaele, Aaron Strong, Jennifer Bouey, Jonathan William Welburn, Pedro Nascimento de Lima, Lawrence Baker, Keren Zhu, Michelle Priest, Lynn Hu, and Jeanne S. Ringel, The Health and Economic Impacts of Nonpharmaceutical Interventions to Address COVID-19: A Decision Support Tool for State and Local Policymakers, Santa Monica, Calif.: RAND Corporation, TL-A173-1, 2020. As of May 06, 2020: https://www.rand.org/pubs/tools/TLA173-1.html, 2020.

𝜎

𝜎

𝜎 = 𝜎 (1 + Δ 20⁄ )

𝜎 = 𝜎 (1 + Δ/5)