The expected increase in bankruptcy risk will also have an impact on the value of debt. Increasing default probabilities may reduce the market value of the outstanding interest and redemption payments and potentially create a wedge between market and book value of debt. Whether this is the case however depends on some clauses in the debt contract itself: If the creditor is allowed to react on the increase of credit risk, e.g. by charging a higher interest
rate, an adjustment of the debt value itself is not necessary. If the creditor does not have the opportunity to adjust credit conditions, then the market value has to be adjusted. Recalculating the value of debt shall include the higher default risk; option pricing models are helpful here.
It is important to note that this adjustment will only affect the debt currently outstanding. Any new credit negotiated in later years will fully reflect the (then prevailing) market conditions and thus have no material impact on the current value of the firm.4 Thus the effect on the current market value of debt will depend on the remainder time to maturity. For shorter time to maturities it will be of minor importance.
The decrease in debt value caused by COVID-19 will by the same token increase the value of the equity holders. However in the vast majority of cases the negative impact of COVID-19 on the total firm value will be much higher, so that in total equity values are also significantly declining.