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Lawmakers’ proposals to overhaul the US tax regime could lead to a big drop in debt issuance that corporate bond markets are failing to price in, argues Joubeen Hurren.*
The two chambers of the US Congress are currently debating a number of proposed changes to corporate taxes, which could have a major impact on the credit market if they encourage companies to issue less debt.
Among a raft of measures being advanced by Republican lawmakers, three are key from a bond investor’s standpoint: a reduction in the rate of corporation tax to 20 per cent from 35 per cent; a limit on the amount of interest expense companies can deduct from their pre-tax profits; and a temporary deduction in the tax rate paid on repatriated earnings. Each of these measures, if enacted, could lead to a sizeable reduction in new issuance, and a further tightening in credit spreads.
It remains uncertain whether legislators will succeed in pushing any of their reforms through. Since Republicans are seeking to get tax reform through the Senate without any Democratic support, they cannot afford to lose the backing of more than two of their 52 senators. Already it is clear it will not be straightforward to simultaneously placate the moderate and conservative wings of the party.
Financial markets, no doubt mindful of US President Donald Trump’s failure to score a major legislative accomplishment in his first year in office, appear sceptical. This is manifest in various areas. For example, given the tax changes are likely to be expansionary from an economic perspective, one would have expected the US dollar to have rallied this year and yet it has fallen. Since any tax giveaway would probably boost inflation it would have been reasonable to expect the US yield curve to have steepened and yet it has flattened. Similarly, one would have anticipated shares in high tax paying companies to have outperformed lower tax payers. And yet, as the chart below shows, since the start of this year the reverse has been the case. As for corporate bonds, although credit spreads have tightened this year, there is little evidence this has had anything to do with investors anticipating changes in the tax regime.
High tax paying stocks underperform S&P 500
However, while the odds may be against a major overhaul of the tax regime being passed, the probability of success is greater than markets appear to believe. Many Republicans view a win on overhauling the tax code as crucial ahead of 2018’s congressional elections. Since any of the proposed changes could result in reduced supply, US corporate bonds have begun to look undervalued relative to other international credit markets.
Cut in corporate tax rate
Among the three significant changes from the bond market’s perspective, a lower corporate tax rate would be likely to influence prices in two ways. First, by increasing net profits, it would improve companies’ ability to service their debt. Second, since a lower tax rate would reduce the size of the so-called tax shield, issuing debt would become more expensive relative to the cost of equity funding, encouraging companies to reduce leverage.
At present, companies can deduct debt interest payments from pre-tax profits in determining their tax bill. That means with a 35 per cent corporate tax rate, for every $100 of debt interest costs a company incurs, the net cost is actually $65, since it pays $35 less tax. With a 20 per cent corporate tax rate the net cost of the same $100 of debt interest would rise to $80.
In a recent research note, Barclays estimated that in view of the historical positive relationship between corporate tax rates and leverage, a cut in the corporation tax rate of the magnitude currently proposed could lead to a decrease in leverage of around 25 per cent. 2
Barclays reckons that could in turn lead to the spread on the wider US corporate bond market tightening by almost 25 basis points and on the industrial sector by as much as 40 basis points. Moves of this magnitude would depend on the tax cuts being made permanent as companies would be unlikely to make radical changes to leverage in response to temporary rules. Even if they were permanent, it could take as much as a decade for companies to fully adjust their leverage ratios.
The second reform of major relevance to bondholders would see the amount of interest companies could deduct from their pre-tax profit limited to around 30 per cent of earnings before interest, taxes, depreciation and amortisation.
Somewhat counterintuitively, while the proposal would be bad news for companies as it would hit their profits by reducing the size of the ‘tax shield’, it would spell better news for investors since it would make it less economical for companies to issue debt.
That would be especially true in the case of high-yield bonds. Since high-yield issuers tend to be the most heavily indebted, they would have the biggest incentive to reduce leverage. Not only would supply likely shrink, but by deleveraging, these issuers’ credit quality would improve, providing a further boost to bond prices.
Nevertheless, these potential positive effects on bond markets would depend on legislators implementing the changes very gradually. High-yield borrowers would need plenty of time to restructure their balance sheets. Failing to do this would likely cause most of these companies major problems as they would struggle to reduce leverage quickly. Even then, the change is likely to present an existential threat to particularly heavily leveraged companies, notably in the energy sector.
As for the third proposed change – a temporary deduction in the tax rate paid on repatriated foreign earnings – it has the potential to depress some yields appreciably. In this case debt issued by major multinationals, particularly in the technology and pharmaceutical sectors, would be the main beneficiary.
At present, when repatriating earnings firms are obliged to pay the difference between the US corporate tax rate of 35 per cent and what they have already paid in the nation where they booked the profits. For example, if a pharmaceutical or technology giant repatriates profits from Ireland, where the top rate is 12.5 per cent, it would face an additional tax rate of 22.5 per cent.
However, under GAAP accounting rules, a company that reinvests foreign earnings abroad ‘permanently’ to expand its foreign operations – or even plans to invest funds sitting in cash at a later date – doesn’t have to pay tax on those earnings unless they are repatriated.
Not surprisingly, with the US corporate tax rate comparatively high by international standards, many businesses choose to hoard their cash overseas. Moody’s estimated the cash pile to be worth $1.84 trillion at the end of 2016. 3 Apple alone had $269 billion of cash and marketable securities sitting on its balance sheet at the end of September, $252 billion of which was stashed abroad. 4
The House of Representatives, as of writing, is proposing cutting the maximum levy companies pay on repatriated profits to 14 per cent where it is held as cash and seven per cent when held in less liquid investments in order to entice money back to the Unites States.
Companies’ reluctance to repatriate cash held overseas has contributed to the sharp rise in investment-grade bond issuance over the past decade.
US investment grade new supply
This debt has been used partly to fund acquisitions, but it has also enabled companies to buy back their own stock. Since the earnings yield in the equity market was so much higher than the cost of issuing debt, selling bonds to buy their own shares provided companies an easy way of boosting shareholder returns.
If companies are now given an incentive to repatriate cash the result could be a huge shift in the structure of investment-grade companies’ balance sheets, with big implications for bond markets. Suddenly, after a couple of years of record issuance, it could be about to get more economical for companies to start buying back debt rather than selling it. For instance, with a tax ‘amnesty’ Apple, which last year issued $24 billion of debt to fund share buybacks, would not need to issue any debt at all.
It seems reasonable to expect gross issuance of investment grade debt, which has averaged just over $1 trillion in recent years, would fall sharply in the event an amnesty were granted.
Interestingly, while investors appear wary of anticipating any of these tax changes, companies themselves have been less reticent. According to data compiled by Bloomberg, US firms have sought to buy back $178.5 billion of bonds so far this year, compared with $87.3 billion at the same point last year. 5 In recent weeks companies including Verizon, Comcast Corp and WalMart Stores have bought back billions of dollars of their own debt. While none has explained why, it seems likely much of the activity is being driven by possible tax changes.
In each case these companies have been buying back bonds with high coupons trading well above their par value. For instance, WalMart on October 6 launched a tender to buy back up to $8.5 billion of outstanding debt, the majority with high coupons and long maturities. 6 The rationale for buying such bonds is that the retailer is effectively deemed to be ‘pre-paying’ interest it was scheduled to dole out for years and deduct it from its 2017 income while tax rates are still high. That will prove astute if either tax rates end up falling or the expensing of interest is curbed.
While the spread on US investment-grade bonds looks tight from a historical perspective, it could yet fall further as and when uncertainty surrounding the precise form the tax reforms take begins to lift.
1 Chart compares performance of a basket of stocks in 49 high tax paying companies (with a 10-year median tax rate of 38%) with the S&P 500 index (median tax rate of 30%).
2 Barclays Credit Strategy research note published 26 Oct 2017
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 20 November 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.