Posted: 30 / 09 / 2022

Article by Harris Jones, Corporate Finance Associate at Sedulo

Last week, news came from the Bank of England with a statement that the UK is in a recession and interest rates had to be raised to tackle the worst period of inflation for 40 years.

A majority of the bank’s nine-member monetary policy committee (MPC) voted to increase the key base rate by 0.5 percentage points to 2.25%, arguing that the risks of inflationary pressures becoming ingrained outweighed the short-term dangers to the economy. The 2008 financial and economic crisis resulted in a severe contraction in money and credit markets which produced ultra-low interest rates, and these interest rates are what the United Kingdom have become accustomed to over the past 14 years.

When looking through a wider lens, the recent increases in interest are still lower than pre-2008. Nevertheless, this trend of rising interest rates is set to continue for the foreseeable future, meaning that the increasing burden that falls upon companies for the costs of borrowing is becoming more severe.

The issue is intensified by the rise in the yield on UK government bonds. Higher bond yields may seem abstract to anyone outside of financial markets; however, government bond yields are the basis for setting rate of interest which companies pay on their corporate debt. Bond prices have an inverse relationship with interest rates, which essentially means that when interest rates go up, bond prices go down and vice versa.

Therefore, rising bond yields directly increase the cost of new government borrowing, and indirectly raise interest rates for households and businesses.

Reuters have reported that Britain’s bond market suffered its biggest daily fall in decades on Friday.

UK 5-year bonds suffered the biggest daily fall in 31 years and Sterling falling 3% to a 37-year low below $1.09 and is expected to decline further. Moreover, finance minister Kwasi Kwarteng’s plans will require an extra £72 billion of government borrowing over the next six months alone and making permanent tax cuts costing £45 billion a year, which is a particular concern for investors. Ben Nabarro and Jamie Searle, economist and bonds strategists at Citi Bank, commented that Fridays “fiscal announcement constitutes a huge, unfunded gamble for the UK economy”.

Under the previous government’s plans, the rate of UK Corporation Tax (CT) was to increase from 19% to 25% from April 2023. However, CT will no longer rise as previously planned. At 19% the UK CT rate is significantly lower than the rest of the G7 and the lowest in the G20. Amongst some of the positives this may bring, a negative is that the tax shield for companies will now be reduced.

(The Interest Tax Shield refers to the tax savings resulting from the tax deductibility of the interest expense on debt borrowing)

Interest Tax Shield = Interest Expense x Tax Rate %

Based on the information announced last week from the Mini-Budget and the current economic environment, there appears to be a strong argument to de-gear and switch to equity as an investment option as opposed to using debt investment. De-gearing is the process in which a company changes its capital structure through changing its long-term debt to equity, which essentially eases the financial burden of interest payments.

Have questions about your investments?

At Sedulo Corporate Finance, we have a strong record of advising shareholders on maximising their capital structures and raising Private Equity Investment, leveraging our extensive contacts and industry knowledge.

If you have any questions about the information above, or would like to learn more about the decision between debt and equity financing, please contact Harris Jones, Corporate Finance Associate at Sedulo, by emailing or by calling 0113 518 7952.