Corporates across the globe have borrowed billions using unquoted loans, unquoted bonds and private placements. They are a fundamental funding source for the economy, spanning corporates, real estate, public and private infrastructure. As well as traditional lenders, these are held as investments by investment funds, pension funds and insurers. They are therefore a critical component of the financial system.
Unquoted debt instruments are hard to value and their valuation has recently become even harder due to COVID-19. The resulting market volatility has created the most challenging valuation environment in more than a decade:
During such times it emphasises the importance of understanding the value pre- and post transactions to support strategic decisions, as well as robust and transparent valuations in financial reporting. Understanding borrowers’ credit worthiness is crucial to value and valuations might differ materially based on market data inputs used whilst estimating illiquidity premia becomes more material. A prolonged lockdown could put pressure on Sovereign credit ratings which would apply even more pressure on UK corporate credit spreads.
Below, we have explored the impact of COVID-19 on Investment Grade Corporate debt and credit markets in the UK. We have analysed Bond2 spreads (measure of corporate credit risk), Bond-CDS3 basis per Corporate (a measure of short-term funding stress) and Bond & CDS bid-offer spreads (a measure of liquidity).
There have been a large number of downgrades by credit rating agencies, and credit spreads are soaring. Airlines and Car Manufacturing have seen the most increase in credit spreads and illiquidity whilst the impact has been less sizable for Consumer Goods and Pharmaceuticals. This is expected to be due to panic buying of consumer goods and a search for yield for potential vaccine providers. All industries have been affected.
Valuers tend to use quoted bond benchmarks and/or CDS benchmarks for debt valuations, however we are seeing the difference between CDS and Bond spreads for Corporates diverge significantly across all industries. Airlines and Banking are the two industries where this is most pronounced, with the increase in bond spreads being greater than the increase in CDS spreads.
Market liquidity has deteriorated across all markets considered, especially Airline industries. Bond bid-ask spreads (a measure of liquidity for bond transactions) have widened across industries.
Compared to the Global Financial Crisis in 2008, volatility in credit spreads is less pronounced which is due to governments acting to support businesses.
Charts were generated using daily bond mid z-spreads for vanilla bonds and option adjusted spreads for callable bonds sourced on Refinitiv Datastream. Bond z-spreads were sourced from liquidly traded, senior unsecured bonds with a time to maturity close to 5Y.
2 bond spreads meaning zero volatility spreads, i.e.the bond spreads over LIBOR
3 CDS refers to credit default swaps