Default Correlation Among Non-Financial Corporate Affiliates

Abstract

Corporations often issue debt securities through multiple legal entities, whose default experiences are likely to be strongly, but imperfectly, correlated. In the absence of iron-clad cross-guarantees across affiliates, a single entity may default while some or all its affiliates may not. Risk managers need to anticipate default correlation in order to evaluate the diversification benefits of investing across affiliates. Similarly, portfolio managers need to anticipate default correlation to assess the relative value of debt securities issued by different corporate entities. To our knowledge, this paper presents the first research on the default correlation of affiliates within corporate families.

Based on an analysis of the 152 non-financial corporate families with multiple rated entities at the time of their defaults between 1999 and 2004, we find that: - When one affiliate defaults, all of its affiliates default about 80% of the time, and at least one affiliate avoids default 20% of the time. - Firm characteristics that increase the likelihood that at least one affiliate avoids default include:  Investment-grade ratings within three years of default,  Presence of regulated affiliates,  Presence of international affiliates,  Presence of utilities or media affiliates, and a  A large number of affiliates in the family. - Among these characteristics, only the presence of investment-grade ratings and regulated affiliates were statistically significant in a multivariate regression model. - Rating differentials across affiliates tend to be wider when some affiliates avoid default. The magnitude of rating differentials within the family one year prior to default is the single most important predictor of whether or not some affiliates avoid default.

Keywords: default, credit ratings, default correlation