Credit Spreads: Comparing COVID-19 to the Collapse of Lehman Brothers

Credit Spreads: Comparing COVID-19 to the Collapse of Lehman Brothers

On March 18, Reuters noted something I have been following of late:

Concerns about the impact of the coronavirus on corporate America’s balance sheets has tripled the premium investors are demanding to hold even the highest-rated corporate bonds. The difference between the average yield of investment-grade U.S. bonds over virtually risk-free Treasuries widened to 303 basis points (bps) on Wednesday, according to the ICE/BofA investment grade index. That’s up from 101 bps at the start of the year and the highest since July 2009, For riskier high-yield securities, the average spread over Treasuries on Wednesday was 904 bps, the highest since October 2011, and more than 2-1/2 times the rate at the start of the year, using the ICE/BofA high-yield index … This hit to earnings has come at a time when U.S. corporate debt is near all-time highs, as is the size of the so-called triple-B segment of the market – companies one notch above junk status.

The spread between long-term corporate bond rates with credit rating BBB and long-term government bond rates jumped very quickly to almost 4%, which was not quite as high as the 5% or more spreads observed after the collapse of Lehman Brothers. FRED provides a series entitled ICE BofA BBB US Corporate Index Option-Adjusted Spread that dates back to 1997 when this spread was modest. It hit sort of a tidal wave during the turn of the millennium with the collapse of the internet/computer/telecommunication boom and a host of notorious bankruptcies. What happened after the collapse of Lehman Brothers was a tsunami. I did find some Thomson Reuters discussion entitled the implications of the credit crunch for intercompany loans, which talked about market interest rates as of February 2009:

Spreads for even AAA-rated long-term corporate debt, however, have recently been higher than 100 basis points, while spreads for borrowers with lower credit ratings have been much higher.

Its figure 2 shows that the spread for BBB-rate long-term corporate debt jumped to above 500 basis points. The thrust of this paper seems to be that U.S. affiliates were about to incur a lot of intercompany debt with their foreign parents. The recent Reuters story alludes to the potential need for U.S. companies for debt as we work through this COVID-19 crisis. It is ironic that the OECD just released its Transfer Pricing Guidance on Financial Transactions, which spends 46 pages making basic economic issues as convoluted as possible. But that is what international tax attorneys do. Cutting past all the legalese blah, blah, blah – it does make the important point that estimating a borrower’s credit rating is both controversial and challenging. But once one estimates a credit rating – which is a letter grade – it needs to be translated into a numerical credit spread. As the tsunami following the collapse of Lehman Brothers showed – credit spreads can jump very quickly. It seems the COVID-19 crisis is following suit.