The COVID-19 Impact on Corporate Leverage and Financial Fragility

We study the impact of the COVID-19 recession on capital structure of publicly listed U.S. firms. Our estimates suggest leverage (Net Debt/Asset) decreased by 5.3 percentage points from the pre-shock mean of 19.6 percent, while debt maturity increased moderately. This de-leveraging effect is stronger for firms exposed to significant rollover risk, while firms whose businesses were most vulnerable to social distancing did not de-lever relative to less vulnerable companies. We rationalize our evidence through a structural model of firm value that shows lower expected growth rate and higher volatility of cash flows following COVID-19 reduced optimal levels of corporate leverage. Model-implied optimal leverage indicates firms severely affected by lockdowns became over-leveraged. We find default probability deteriorates most in large, over-leveraged firms and those that were stressed pre-COVID. Additional stress tests predict value of these firms will be less than one standard deviation away from default if cash flows decline by 20 percent.