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Corporate Bond Spreads and the Pandemic IV: Liquidity Buffers


Friday, June 12, 2020
Stock image stocks, financial data, pocket calculator and a pen

By Julian Kozlowski, Senior Economist, Miguel Faria-e-Castro, Economist, and Mahdi Ebsim, Research Associate

The COVID-19 outbreak has led to significant financial market disruption that has resulted in a marked increase in corporate bond spreads. In previous blog posts, we have documented this large increase during the first weeks of March and how it was contained by Federal Reserve announcements on March 23. We also showed that the evolution of credit spreads has been quite different across different sectors, hitting sectors such as accommodation and food services much more heavily than sectors such as utilities.See our previous blog posts: I, II, III. A recent paper by Mahyar Kargar and others found that in mid-March, as selling pressure surged, dealers were wary of accumulating inventory on their balance sheets. As a result, the cost to investors of trading immediately with a dealer surged. A portion of transactions migrated to a slower, less costly process wherein dealers arranged for trades directly between customers without using their own balance sheet space.

In this post, we study the relationship between movements in credit spreads during this period and firms’ liquidity conditions. Because of the COVID-19 crisis, many firms have experienced sales shortfalls and have been forced to dip into cash reserves to cover costs.In their Chicago Fed blog post, Nicolas Crouzet and François Gourio project that by the third quarter of 2020, 30% of public corporations in the U.S. will have a zero cash balance if no adjustment to operations takes place, and 10% if investing activity is put on hold. Although most firms have experienced increases in their cost of borrowing due to general turmoil in financial markets, we found that firms with better liquidity conditions—measured as the share of liquid assets (or liquid net worth) in total assets—tended to experience smaller increases in credit spreads.

Measuring Liquidity at the Firm Level

First, it is important to define what we mean by liquidity, as this term can have different meanings depending on the context. Here, we are interested in measures of “funding liquidity”—that is, measures of how much cash or cash-like assets firms have available to meet short-term funding needs and expenses. Because of the outbreak and public health policy responses, many firms saw their business and sales decline considerably—and in certain sectors, such as restaurants and hotels, almost completely.

To study the relationship between movements in credit spreads and firms’ liquidity conditions, we combined firms’ financial statements with the credit spreads of their bond issuances. We computed credit spreads using Mergent FISD and TRACE (FINRA) data (details provided in a previous blog post). We used Compustat for firms’ financial statements. We linked firms in Compustat to firms’ credit spreads via ticker information and six-digit CUSIP ID. We removed firms in finance, insurance and utilities. Our sample is a total of 665 firms. We observed their financial position in the fourth quarter of 2019, before the COVID-19 crisis, and subsequently the credit spreads on their bond issuance throughout the first quarter of 2020.

The table below presents some summary statistics on our sample of firms. The first line presents statistics on the ratio of liquid assets to total assets, showing that 9% of assets are liquid for the average firm. The second line presents statistics on “liquid net worth” divided by assets. Liquid net worth is the difference between liquid assets and debt in current liabilities (notes payable and long-term debt due within one year). This is a proxy for how much cash the firm can produce to meet short-term funding needs after repaying its short-term debt commitments. Naturally, the average is smaller than that for liquid assets to total assets in the first line.

The final line presents summary statistics on the average increase in credit spreads between the start of financial market disruptions at the end of February and the announcement of emergency measures by the Federal Reserve on March 23.

Table 1: Summary Statistics of Select Firms
Variable Mean Median Standard Deviation
Liquid Assets to Total Assets (Ratio) 0.09 0.05 0.10
Liquid Net Worth to Total Assets (Ratio) 0.05 0.02 0.11
Change in Credit Spreads (Basis Points) 253.69 170.25 243.56
SOURCES: Compustat, Mergent FISD,TRACE and authors’ calculations.

The Relationship between Liquidity and Credit Spreads

The tables below present regression results of the change in credit spreads due to the “turmoil” between Feb. 29 and March 23 on our two measures of liquidity (liquid assets to total assets and liquid net worth to total assets) and a collection of controls. As controls, we included variables that are also correlated with rising credit spreads as controls: firm leverage (ratio of total liabilities to assets) and firm size (log of total assets). Moreover, in all our results we controlled for the firm’s sector.

We combined our measures of liquidity and controls in a number of combinations to insure our results are robust. Our benchmark result is the fourth column of Table 2, with liquid assets to total assets and all controls. We interpret the results with the help of our summary statistics table. An increase of 10% in the liquid-assets-to-total-assets ratio corresponds to a one standard deviation increase in the data. From our benchmark results, a one standard deviation increase in liquid assets to total assets is associated with an increase in credit spreads that is 18 basis point smaller (-177 x 0.10).

Table 2: Dependent Variable: Change in Average Credit Spread, Feb. 29–Mar 23
(1) (2) (3) (4)
Liquid Assets to Total Assets -152.711* -122.040 -208.363*** -177.090**
(82.747) (80.739) (79.884) (79.182)
Leverage 285.035*** 204.795***
(47.348) (48.030)
Size   -43.386*** -36.186***
(5.884) (6.048)
Number of Firms 665 665 665 665
R2 0.25 0.29 0.30 0.32
NOTES: Sectoral FE. Standard errors in parentheses. * p < 0.10, ** p < 0.05, *** p < 0.01.
SOURCES: Compustat, Mergent FISD, TRACE and authors’ calculations.
Table 3: Dependent Variable: Change in Average Credit Spread, Feb 29–  Mar 23
(1) (2) (3) (4)
Liquid Net Worth to Total Assets -168.185** -104.036 -232.663*** -178.218**
(74.870) (73.835) (72.364) (72.874)
Leverage 279.548*** 192.234***
(47.795) (48.666)
Size     -44.181**** -37.101***
    (5.884) (6.088)
Number of Firms 665 665 665 665
R2 0.25 0.29 0.31 0.32
NOTES: Sectoral FE. Standard errors in parentheses. * p < 0.10, ** p < 0.05, *** p < 0.01.
SOURCES: Compustat, Mergent FISD, TRACE and authors’ calculations.

Table 3 repeats the regression exercise of Table 2 with an alternative definition for liquidity—liquid net worth to total assets—and reaches similar results: The fourth column presents results which also imply that a 10% increase in liquid net worth to total assets is associated with an increase in credit spreads that is 18 basis points smaller.

In conclusion, this result likely reflects market participants’ beliefs that firms with more liquidity are better able to withstand a period of low sales and reduced business activity. During these periods, a more-liquid firm can survive longer by running down its liquid assets to pay for expenses that are not related to the core business. This increased probability of survival is taken into account by financial markets and corporate bond investors, who then reward the firm with a smaller increase in its cost of borrowing.

Notes and References

1 See our previous blog posts: I, II, III. A recent paper by Mahyar Kargar and others found that in mid-March, as selling pressure surged, dealers were wary of accumulating inventory on their balance sheets. As a result, the cost to investors of trading immediately with a dealer surged. A portion of transactions migrated to a slower, less costly process wherein dealers arranged for trades directly between customers without using their own balance sheet space.

2 In their Chicago Fed blog post, Nicolas Crouzet and François Gourio project that by the third quarter of 2020, 30% of public corporations in the U.S. will have a zero cash balance if no adjustment to operations takes place, and 10% if investing activity is put on hold.

3 We computed credit spreads using Mergent FISD and TRACE (FINRA) data (details provided in a previous blog post). We used Compustat for firms’ financial statements. We linked firms in Compustat to firms’ credit spreads via ticker information and six-digit CUSIP ID. We removed firms in finance, insurance and utilities.

Additional Resources

Posted In Financial  |  Tagged julian kozlowskimiguel faria-e-castromahdi ebsimcovid19coronavirusbondscorporate bonds