Covid-19 and the credit cycle

Edward I Altman

Abstract

The Covid-19 health crisis has dramatically affected just about every aspect of the economy, including the transition from a 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. We analyze the performance of several key indicators of the nature of credit cycles: default and recovery rates on high-yield bonds, and the number of large firm bankruptcies that we expect over the next twelve months and beyond; yield spreads and distress ratios; and liquidity. Our focus is primarily on the nonfinancial corporate debt market in the United States, which reached a record percentage of gross domestic product 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 leveraged loan and collateralized loan obligation markets, as well as the increasingly large and important BBB tranche of the corporate bond market. Specifically, we discuss 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” low-quality debt of other firms (some of which we believe are “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 ratings inflation or, perhaps, persistent overvaluation of the nonfinancial corporate debt market since the last financial crisis.