Monday 27 March 2017 by Mark Bayley Opinion

US high yield bonds and the implications of Trump’s tax plans

We have received several questions from clients regarding the impact of Trump’s tax plans, especially the potential loss of interest deductibility on US high yield companies’ credit quality

trump-tax
​Source: Bruce Plante Cartoons, Tulsa World

There have been several articles on this subject, with varying conclusions.

There are still so many moving parts to this topic:  Will any deal get done?  How much will the tax change?  What will be the impact on the supply of high yield bonds?  How much will it impact company profitability?  Given Trump’s defeat on the repeal of Obamacare, there are big questions about his ability to enact any of his election promises.

In my opinion, given where we are in terms of the credit cycle (mature bull) and current level of high yield credit spreads (tight), the uncertainty around Trump’s tax plan seems like another reason for investors to take some risk off the table while waiting to see how it pans out.

As I have been saying for a while, I believe that in the financial markets the risk versus return equation is very asymmetric; there are big risks to the downside and not much additional return to the upside. This potential tax change adds to those risks, especially in US high yield.

The Economist

The Economist stated:

“Matt King at Citigroup has done some calculations on the winners and losers […] Mr King reckons that only companies with interest cover of more than four times would gain.”

“The upshot could be a sharp divide in the bond market, with investment-grade yields falling and junk-bond yields rising, as investors worry about the ability of the latter to service their debts without the tax benefit. The gap, or spread, between the two would rise as a result (at the moment, spreads are four percentage points, quite low by historical standards). If this took place in an atmosphere of generally rising bond yields, because inflation and economic growth are picking up, then it would be hard for riskier companies to refinance their debts.”

Reuters

Reuters reported:

“But if the proposal is approved by Congress, companies may be forced to rethink their capital structure and raise less debt.  Heavily indebted companies would see their tax bills jump considerably, perhaps even driving weaker companies into default.”

“Domestic issuance volumes in the US could also drop if companies issue more debt in jurisdictions where debt interest tax deductibility remained.”

“The uncertainty and concern over the scope and shape of expected tax reforms is already prompting some blue-chip high-grade names to tap the market while conditions are still good.  This week, for example, AT&T, Apple and Microsoft raised a total US$37bn.  But most issuers are in wait-and-watch mode for now.”

Further, a second Reuters article stated:

Managers of top-performing "unconstrained" bond funds have slashed their stakes in U.S. corporate bonds following a monstrous rally, reflecting skepticism that any tax changes enacted under President Donald Trump can drive prices even higher.”

“Stephen Kane, co-manager of the $3.4 billion Metropolitan West Unconstrained Bond Fund, said yields on junk bonds could widen by up to 5 percent against Treasuries over the next one or two years, which would equate to a roughly 10 percent loss.”

Moody’s

Moody’s has specifically commented on the implications of the new tax reform proposals, summarising the changes in a table:


Source: Moody’s

Specifically, talking about the loss of interest tax deduction, Moody’s stated:

“The loss of deductibility would be particularly punitive for speculative-grade rated companies given their significant leverage and modest interest coverage.”

Moody’s continued:

“Should this reform be phased in only as new debt is issued and existing debt is refinanced – as opposed to grandfathering in debt outstanding – this would further differentiate the effects for investment-grade versus speculative-grade companies.  Since speculative grade companies tend to have shorter dated maturities and are relatively more reliant on short-dated bank credit than investment grade companies, they would incur negative implications earlier.”

There are several other potential impacts.  For example, equity would become a more attractive form of capital than debt, so it is possible that companies could issue more equity – diluting existing holders and putting further pressure on share prices – and have less reliance on debt. 

For bondholders, that has the potential to be positive on two fronts.  Firstly, a company’s credit quality would be improved by having more equity in the capital stack; secondly, there would likely be fewer bonds issued, thus creating a positive technical impact as investors scramble for a dwindling pool of corporate bonds.

Another issue that may impact bondholders is issuers potentially being allowed to redeem bonds at par, due to optional redemption clauses surrounding the elimination of tax deductibility of interest.  However, CreditSights have examined about 70 large issuers across multiple sectors and “found only a handful so far that explicitly tie in interest deductibility to a par call optional redemption.”

Conclusion

While there are still many unknowns and uncertainty, if Trump’s corporate tax plan does succeed and passes into law, then the impact on US high yield companies and their bonds is likely to be negative.  As such, given the strong recent performance of high yield bonds and the current position in the credit cycle, it can be argued that now is a sensible time to take some profits and risk off the table.


Quoted articles:

  1. The Economist: http://www.economist.com/news/finance-and-economics/21716050-would-be-risky-time-fiddle-tax-code-what-if-interest-expenses
  2. Reuters: http://www.reuters.com/article/us-usa-corpbonds-tax-idUSKBN15I2IH
  3. Reuters: http://www.reuters.com/article/funds-unconstrained-idUSL2N1GM20B

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