Updated: Oct 28, 2020
FEON WONG | LEGAL JARGON WRITER
Bonds, a type of debt security, is issued by a company to investors in exchange of capital. Companies prefer bonds to equity as it will not dilute the ownership of shareholders. Before the bond matures (the time when companies need to pay back the sum they borrowed), investors will receive interest payments and are able to trade the bond in secondary markets. As with any investment, the bond’s risk is tied to the return. A company that has a low credit rating and is deemed riskier will normally compensate investors by offering a higher rate.
Attempting to tackle the grave impact brought about by Covid-19, governments in different countries have poured billions to save many desperate companies. Nonetheless, the rescuing act may, instead, hamper the true recovery of the economy. In a world where most, if not all sectors are severely affected by the pandemic, many view the government-granted loans as a “life-saving kit", albeit knowing that the sluggish market is likely to remain for the time being. This means companies, especially small companies operating in retail, oil and travel sectors, may default on the repayment of the state-backed loans expecting to reach £35 bn by next March. To put things into context, junk bonds (bonds that are rated BBB) account for nearly half of the market as compared to a third in 2011. These high-yield risky bonds, once due and defaulted, will put three million jobs in the UK and 780,000 SMEs at risk.
The debt that has been piled up during this period is likely to be unsustainable. Therefore, companies may need to refinance their debts to survive. This can be done through multiple ways. Firstly, it can perform a debt-to-equity swap. In this scenario, equities are issued and capital is raised to pay back the debt. Secondly, the company may choose to reissue new bonds at a lower rate if the market condition allows. This entails buying back old bonds with the money gained from issuing new bonds, thereby allowing the company to pay a lower rate for new bonds.
This is not a problem solely for the UK. In fact, the International Monetary Fund (IMF) mentioned that around £50 trillion has been lent to companies. Contrary to the financial crisis in 2008 where banks were the primary lenders, private equity and hedge funds have become the main lenders this time. Nonetheless, the corporate debt crisis may still return and deepen the recession.
LLB student at The London School of Economics | Communication Officer at Japan Society at LSE
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