On the day Merck announced the withdrawal of its arthritis drug Vioxx, its stock price closed down 27% from the previous day. By the time Moody’s downgraded Merck’s debt to Aa2 40 days later, the formerly AAA-rated company had lost 42%, or $58 billion of its equity value.
Is it time for investors of short-duration corporate securities to head for the exit on Merck? How does one prevent against Merck-like incidents in the future? These are but a few examples of the lingering questions from our corporate treasurer clients regarding their cash portfolios.
Merck’s fall from grace highlights the need to address event risk — a risk that inundates even the most experienced risk managers throughout credit cycles. Here, we offer some perspectives on dealing with this type of risk for corporate cash investors.
What is Event Risk?
Event risk refers to the risk of a severe and sudden loss in a security’s value due to an unexpected event. Such events may include corporate takeovers, operational errors and accounting fraud, stock market crashes, major regulatory changes, terrorism, and natural disasters.
Event risks can be either company-specific or industry-wide. Merck’s drug liability case represents a company-specific risk, while asbestos and tobacco litigations are industry-wide. Credit events can occur any where at any time. Fannie Mae, American International Group, and Shell Oil Company are some of the other AAA-rated companies that have subjected their investors to event risk in 2004.
Characteristics of Event Risk
It is important to be cognizant of the characteristics of event risk to appreciate its potential impact on a portfolio. It can be difficult to predict, frequently causes a liquidity crunch or even crisis, and often results in market contagion.
Difficult to predict: By definition, event risk refers to the occurrence of an adverse corporate or market event that catches the investor by surprise. Either by natural occurrence, such as a major hurricane, or by human design, such as the WorldCom fraud case, credit events often do not provide a clue ahead of their outbreak. When the market is focused on a certain type of event risk, it tends to correct itself until a different type of event risk shows up elsewhere.
Liquidity crunch: Liquidity problems from event risk are two-fold: inability to sell current holdings and reduced credit quality from the credit’s lack of funding. Unlike stocks, which are traded on exchanges, broker-dealers sell bonds “over-the-counter.” In volatile market conditions, liquidity often dries up, thanks to a lack the of interest by broker-dealers to “make a market.” In extreme cases, an investor may not be able to sell a security at all.
A credit event can also trigger a cash flow crisis that shut down an issuer’s funding channels, further reducing its credit quality. Finance companies are particularly vulnerable to liquidity crunches, as they finance major portions of their balance sheets with commercial paper and notes so as to support loan balances and to rollover old debt.
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