Valuation of unquoted debt instruments during COVID-19: hard to value just got even harder

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:

  • Credit ratings are under scrutiny with more than 500 downgrades1 (investment and sub investment grade) by Moody’s, S&P and Fitch in Q1 2020, a large proportion happening in March 2020.
  • Credit spreads are increasing across the board with some sectors impacted more than others.
  • Market standard illiquidity premia are increasing significantly.

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).

Key trends emerging

More than 500 credit rating downgrades in Q1 2020, and credit spreads are dramatically increasing across all industries4

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.

Credit risk benchmarks are diverging

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.

There has been a shock to debt illiquidity

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.

Less volatility during COVID-19 (so far) compared to 2008

Compared to the Global Financial Crisis in 2008, volatility in credit spreads is less pronounced which is due to governments acting to support businesses.

Significant increases in credit spreads could result in significant and sustained decreases in debt valuations across the market for debt
CHART: Significant increases in credit spreads could result in significant and sustained decreases in debt valuations across the market for debt.

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.

What does this mean when you are valuing unquoted loans, bonds and private placements?

  • All industries’ credit profiles and credit benchmarks are materially affected by COVID 19, verifying the credit rating of the borrowers of your debt investments/your own credit ratings for your own liabilities and understanding the idiosyncratic credit risk of each investment are critical. If you need to estimate a credit rating or if the credit rating was generated pre-COVID-19 then these challenges compound.
  • Valuations may be materially different depending on the credit risk benchmarks you select to quantify the impact of credit risk in your valuations. Common benchmarks would be credit spreads implied from CDS or liquidly traded bonds. However, CDS spreads and bond spreads have not moved at the same levels, therefore the use of spreads derived from bonds and CDS from the same issuer could give materially different valuations.
  • Valuations need to incorporate explicit and meaningful estimates of illiquidity premia, as they have become more material than in non-crisis times.
  • The scale of the impact on markets is at crisis levels. Sub-investment grade and unrated companies are likely to be even harder hit than Investment Grade credit rated Corporates. There are many different asset classes within debt markets, and some debt markets are likely to be more exposed and others more less so, for example it is expected that leveraged loans, mezzanine loans and regulated debt markets would respond in very different ways to COVID-19 markets. So far, the Leisure, Entertainment and Retail sectors have been hit hardest for both High Yield and Leveraged loans.

Contact us

Chris Heys

Chris Heys

Partner, PwC United Kingdom

Tel: +44 (0)7715 034667

Annika Buss

Annika Buss

Senior Manager, Valuations, Financial Services, PwC United Kingdom

Tel: +44 (0)7718 976655

Nebil Shubbar

Nebil Shubbar

Senior Manager, Valuations, Financial Services, PwC United Kingdom

Tel: +44 (0)7525 284246

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