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BIS Bulletin No. 26: Corporate Credit Markets After the Initial Pandemic Shock

Core Content

This BIS Bulletin analyzes the impact of the initial pandemic shock on corporate credit markets, focusing on how these markets evolved from early March 2020 to June 2020. It highlights the differences in market behavior across sectors, the role of policy interventions, and the implications for structured finance products like Collateralized Loan Obligations (CLOs).

Key Takeaways

• Corporate funding markets partially resumed after a freeze in mid-March 2020, but with higher spreads and sharper sectoral differentiation.
• Highly rated energy firms saw significant spread increases, indicating a high downgrade risk.
• Post-GFC leverage build-up intensified the effects of financial stress during the pandemic.
• The unusually broad impact of the pandemic on lower-rated firms threatens CLO structures, though not as severely as the housing bubble’s collapse did to CDOs.
• Credit spreads widened sharply in March 2020, especially for sectors facing strong headwinds like travel and entertainment.
• Default risk correlations rose to unprecedented levels, particularly in the high-yield (HY) space, due to increased leverage and worsened liquidity conditions.
• CLOs are more resilient than CDOs because they directly invest in leveraged loans rather than in securitized mortgage-backed securities (MBS).

Market Behavior

• Corporate credit markets froze in March 2020, with issuance nearly ceasing and spreads rising sharply.
• Investment-grade (IG) issuance rebounded quickly, with volumes increasing fourfold by the end of April 2020 compared to typical 2019 levels.
• HY issuance remained weak, with a month-and-a-half pause in late April, and leveraged loan issuance stayed subdued.
• Spreads for HY borrowers remained unchanged by June 2020, while IG spreads improved more significantly.
• Energy firms experienced the highest spreads, even after policy support, reflecting persistent economic uncertainty.

Default Risk and Correlations

• Rating downgrades were concentrated in energy, retail, and entertainment sectors, with oil loans default rate reaching up to 18% in 2020.
• Default correlation increased significantly in the HY space, as well as for leveraged firms, due to shared liquidity stress and high leverage.
• Correlation between bond and commercial paper (CP) spreads reached 70–80% in early 2020, double the 2008 levels, due to synchronized financial distress.
• Correlations declined after policy interventions, but remained elevated in the riskier corners of corporate credit markets.

CLOs and Structured Finance

• CLOs are vulnerable to rising default correlations, which could lead to significant losses for AAA tranches.
• CLOs differ from CDOs in that they do not involve layered securitizations, thus reducing the amplification of default correlations.
• CLOs resemble MBS more closely than CDOs, and historical loss rates for MBS during the 2008 crisis are comparable to the expected losses from a simplified model.
• Insurance companies and hedge funds hold AAA and mezzanine CLO tranches, which could be affected by unexpected losses due to asset-liability mismatches and leverage.

Factors Affecting CLOs

• Errors in risk assessment could lead to unexpected losses, especially for mezzanine and AAA tranches.
• Hedge fund leverage has increased over the past five years, potentially amplifying the impact of CLO losses.
• Limited complexity in CLO structures is likely to dampen the effects of rising default correlation.

Conclusion

The initial pandemic shock caused severe disruptions in corporate credit markets, leading to higher spreads, sectoral imbalances, and increased default correlations. While policy interventions helped restore market activity, they did not fully return to pre-shock risk pricing. The impact on structured finance like CLOs is significant, but less severe than the CDO crisis of the GFC. CLOs are more resilient due to their direct investment in leveraged loans and simpler structure.

References

• Antoniades, A and N Tarashev (2014): "Securitisations: tranching concentrates uncertainty", BIS Quarterly Review, December 2014.
• Aramonte, S and F Avalos (2019): "Structured finance then and now: a comparison of CDOs and CLOs", BIS Quarterly Review, September 2019.
• Banerjee, R, A Iles, E Kharroubi and JM Serena (2020): "Covid-19 and corporate sector liquidity", BIS Bulletin, 28 April 2020, no 10.
• Cordell, L, G Feldberg and D Sass (2019): "The role of ABS CDOs in the financial crisis", Journal of Structured Finance, Summer 2019, vol. 25, no. 2.
• Foley-Fisher N, B Narajabad and S Verani (2019): "Assessing the size of the risks posed by life insurers' non-traditional liabilities", FEDS Notes, 21 May 2019.
• Graham, JR and MT Leary (2018): "The evolution of corporate cash", Review of Financial Studies, November 2018, vol. 31, no 11.
• Vasicek, O (1991): "Limiting loan loss probability distribution", KMV Corporation.