COVID-19 and credit risk: A long memory perspective

Area of Science:

• Finance
• Econometrics
• Risk Management

Background:

• Credit risk is a primary concern for corporate bondholders, especially insurance companies.
• Credit risk is typically quantified by agency credit ratings and credit default swaps (CDS).
• Credit risk often exhibits long-range dependence (LRD) due to persistent credit rating patterns.

Purpose of the Study:

• To investigate the impact of the COVID-19 pandemic on credit risk dynamics.
• To analyze the shift in dependence regimes of default intensities during the pandemic.
• To compare the pandemic's effect on LRD with previous financial crises.

Main Methods:

• Utilized rescaled range analysis.
• Employed a novel affine forward intensity model with flexible Hurst parameters.
• Analyzed Moody's rating data and credit default swap (CDS) prices.

Main Results:

• Default intensities shifted from LRD to short-range dependence during the COVID-19 pandemic.
• This shift implies historical credit performance is less relevant for pandemic-era credit prediction.
• The decline in LRD during COVID-19 was more pronounced than observed during the 2008 subprime mortgage and Eurozone crises.

Conclusions:

• The COVID-19 pandemic significantly altered credit risk behavior, moving it from a long-range to a short-range dependence regime.
• Historical credit data's predictive power for insurers' investments is diminished during such crises.
• Understanding these regime shifts is crucial for effective credit risk management and investment strategies.