Estimating the Impact of COVID-19 on Corporate Default Risk

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.