Although the COVID-19 pandemic led to a record number of downgrades in 2020 and 2021, corporate default rates remained low, thanks to the huge level of government support. Yet despite its success, public intervention of this type and scale may not be replicated for future crises.

Lockdowns meant that many corporates were unable to operate under normal conditions. Some consumer-facing businesses were forced to close stores, while production businesses, such as the automotive industry, suffered supply chain issues that created significant cost overruns. The sudden stop of earnings led to a ratings decline steeper than that experienced in the 2008 financial crisis (see chart 1), and had the potential to create a global corporate liquidity crunch.

Chart 1

Yet this significant worsening in rating levels ground to a halt as further credit stress and defaults were avoided. Despite a record level of downgrades since the start of the pandemic and a significant share of our rated corporate universe being downgraded to 'B-' or below, corporate default rates have remained low. This decoupling between credit quality and default rates is unprecedented.

Chart 2

To mitigate the effect of lockdowns, government support in most developed markets was systemic and massive. Compensating for the disruption arising from government-induced lockdowns, or from the pandemic's side effects, governments provided sufficient liquidity to keep the economy afloat and made significant fiscal investments to help reignite demand.

Government support also led to a significant distortion in household income, compared with every other recession in history (see chart 3). As income soared and savings built up amid a strong recession, the economic recovery sprang to life significantly faster than our base case anticipated, in particular for cyclical sectors such as retail, oil and gas, and metals and mining.

Chart 3

Chart 4

Political Intervention Makes Economic Outcomes Less Certain--And More Extreme

The nature of the COVID-19 pandemic and the public policy response made forecasting more difficult, leading to a more volatile rating transition. This translated into high volatility in corporate ratings over the past two years, with two key factors:

• The complete shutdown of financial markets amid the pandemic leading to a wave of downgrades, because of a significant rise in refinancing risk for issuers with upcoming maturities. That said, financial markets quickly reopened as central banks poured abundant liquidity into the system, and most of the downgraded issuers were able to refinance their capital structure; and
• The scale and breadth of government support resulting in a stronger recovery for most corporates than originally anticipated. This also explains the sustained improvement in rating levels throughout 2021 despite the continuing pandemic restrictions.

In essence, because political decisions were driving economic activity, potential outcomes were rendered less certain, more extreme, and more abrupt than in a conventional, endogenous credit event.

Chart 5

Government intervention also suppressed corporate credit risk premium. By supporting income and preventing defaults, government support became embedded in financial markets' perception of corporate credit risk. Consequently, the amount of corporate debt issued soared in 2020 and 2021, particularly in the speculative-grade (rated 'BB+' or lower) space. In the meantime, corporate credit spreads tightened meaningfully, despite deteriorating credit metrics and worsening credit ratings (see chart 6).

Chart 6

Government support prevented defaults, but the inflationary effects of the pandemic changed the form of debt value destruction. The quick economic recovery, facilitated by government support, prevented nominal corporate defaults, but as a result started to erode the real value of debt at a higher pace--in essence, socializing the cost of default, because inflation can transfer wealth from lenders to borrowers. Consequently, viewing default rates in isolation misses the full picture of the debt value destruction generated by the pandemic, because it focuses solely on the nominal value and omits the loss of future purchasing power for debtholders.

Replication Of The COVID-19 Response Is Unlikely

The response to the COVID-19 pandemic is not necessarily systematically replicable. The ability for governments to anticipate and react to the pandemic has been helped by the nature of the crisis. As a consequence, the probability that governments would be willing and able to provide the same kind of support in different circumstances is low, in our view, for several reasons and despite potentially very large financing needs in relation to the energy transition.

Government-led, government-solved

Because of the identifiable and legitimate nature of the recession--that is, as a result of governmental measures taken to limit the pandemic's spread--the systemic risks to the economy were identifiable and could be anticipated by governments. In contrast, more "normal" credit events tend to stem from endogenous imbalances, and are multifactorial and unanticipated as a result. A public intervention in such cases tends to be less consensual and legitimate, because it often creates a form of moral hazard, as seen in the 2008 financial crisis.

The pandemic's global nature allowed for political consensus in developed markets on the need for large, synchronized fiscal and monetary stimulus, regardless of the sovereigns' relative creditworthiness

The conversion of fiscal and monetary policies across the globe allowed less financially sound countries to run large deficits with still-facilitated access to financial markets and unencumbered foreign exchange considerations. Emerging from the pandemic, we observe a progressive normalization of monetary policies, characterized by interest rate hikes and balance sheet reduction. This is creating increased volatility in the currency markets--such the euro or the Chinese renminbi--and may lead to heightening financing pressures on countries running high public and private debt-to-GDP ratios, because the cost of debt is likely to soar and spreads are likely to widen again.

Chart 7

Sovereign fiscal headroom has decreased and the legitimacy of systemic intervention depends on the nature of the crisis

The pandemic took a toll on public finances around the world. Some sovereigns' debt-to-GDP ratios reached unprecedented levels. Consequently, governments' ability to reiterate this level of support in each economic crisis may become questionable. In addition, a more systematic form of intervention can foster moral hazard, as risk takers may assume that ultimately some form of public intervention will mitigate the effect on the global economy of aggressive risk taking (the 2008 financial crisis is one illustration; the debt-fueled real estate crisis in China another).

So far, we observe that public policy response in developed economies has leaned toward favoring the support of the economy regardless of the nature of the crisis. In the U.S., for instance, the size of the deficit needed to support the economy after a recession has increased relentlessly over the past 50 years, regardless of the amplitude and nature of the recession (see chart 8). Lastly, even if such a policy response were to be replicated over time, to mitigate the potential harmful effect to the economy, inflation control could be the ultimate limit to public intervention. While central banks from developed economies have largely monetized the additional debt arising from these deficits, such interventions may not be endlessly repeatable over time without risking their credibility in terms of executing their mandates to keep inflation in check and maintain a reliable currency.

Chart 8