Banks have done few favours for small companies since the credit crunch. Now the government – which has no love of banks either, having ruined the national accounts to rescue them – is looking for ways to cut out the traditional lenders.

In future, small and medium businesses may find they have a choice of issuing a junk bond instead of taking a bank loan. If that merely makes the banks more competitive and more inclined to lend, it will have worked, but if companies choose to mix their sources of funds they will have healthier balance sheets too.

The idea of alternative forms of finance was floated in December’s  pre-budget report and has now emerged as a discussion document from the Treasury. Ministers have noted that big companies have circumvented the banks by issuing bonds and wonder why smaller companies shouldn’t follow. It works in America, the Treasury notes, and might work here.

The reason small companies don’t issue bonds is primarily that small companies don’t issue bonds. No-one wants to be first. But even if the issuing costs can make them a profitable source of capital, they will work only if investors want them, and that will mean creating the infrastructure of a market, even if they are not traded on a formal exchange.

Some sort of respected credit rating for small-company bonds would be a starter, along with an index of the market to give bondholders a benchmark. It may be necessary to waive the rules to allow retail investors to buy too, and a secondary market must develop so that bonds are tradable to give investors liquidity. Standardising the terms of bonds – preferably on a Europewide basis – would help too.

Overcoming those barriers is a tall order, but it has been done in the equity markets through the creation of the unlisted securities market, Third Market, Aim and Plus. The best aid to development is volume; that provides liquidity and overcomes the reluctance of both issuers and investors to try something new. And volume will bring down the issue fees, the yield and the spreads.

Small companies will always have to pay a premium to raise cash – hence these will be high-yield, or junk, bonds – but compared with high borrowing costs or the impossibility of finding bank finance, that can still be a bargain.

But who will create this market and who will issue the bonds? Unfortunately it will be the same investment banks that the government so hates.

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