This commentary originally appeared on Real Money Pro at 1:30 p.m. EST on Feb. 8. Click here to learn about this dynamic market information service for active traders.
How will corporate tax reform impact the corporate bond market? There are some very important implications for credit investors, as well as some implications for certain stock investors, if something like the tax plans of either House Speaker Rep. Paul Ryan, R-Wis., or President Donald Trump eventually become law. This basically breaks down into two categories: implications for corporate quality and implications for corporate decision making.
For this discussion, we are going to assume a tax plan that lowers the statutory tax rate to 20%, allows for immediate expensing of capital expenditures, does not allow expensing of net interest costs and a border-based system. In this context, the main difference between Ryan and Trump's plan is that the president would allow companies to choose either immediate capex expensing or interest expensing. For simplicity we will go with the Ryan plan.
On balance, more companies would benefit from lower headline rates, immediate expensing of capex and the ability to bring cash back from overseas than would get hurt by the inability to write off interest. The largest U.S. corporate bond issuer is Verizon (VZ) - Get Verizon Communications Inc. Report . The company paid $4.4 billion in interest in 2016, which it would no longer be able to write off.
But Verizon spent $17 billion in capital expenditures. Hard to know how much of that it got to expense in year one vs. future years, but it seems pretty obvious that between immediate expensing and lower rates, companies like this should come out ahead.
But that isn't every company. Lower-quality high-yield companies are at risk. Take a CCC-rated company called Monotronics, which provides home alarm services. It was acquired by Ascent Media in 2010 in a highly-levered transaction. On the face of it, this is the kind of company that can afford to be highly levered. It gets very steady cash flow and has low capital needs. Effectively, Monotronics act as a middle man between alarm manufacturers and the local dealer who does the actual installation and servicing. In the last 12 months, the company had just $7 million in capex and $123 million in interest expense.
Realizing some tax savings on its interest cost was surely a big part of the calculation when Ascent Media bought the company. As it is, operating cash flow is just $195 million, meaning the company is barely covering interest cost now. Take away the tax benefit, and this might spell serious trouble. I'm only using this as an example, so I'm surely not predicting a default (we used to own the company but do not any longer, so I don't know the intricacies of their tax finances). What I'm trying to point out is there is a swath of highly levered, overwhelmingly domestic and low-capital intensity businesses lurking in the high-yield world.
Investors should realize that a relatively small percentage of companies going into default would materially change the returns for junk-bond funds. In the worst years for junk bonds, the default rate only gets to around 10%. Last year it was around 3%. So an increase of just 4% to 5% would get us most of the way to the worst-case scenario. Or put another way, typically junk bond investors lose 70% on every default. So a 5% increase in defaults would be a 3.5% hit to returns.
The problem might be more acute in the syndicated bank loan market. Floating rate loan funds had been an extremely popular way to play rising rates in recent years. Companies doing large leveraging transactions are over represented in the loan market, and hence this might be a more vulnerable spot.
I don't think you want to passively own high-yield here. The tax-related risk is just one of many reasons, the principal being that valuations are tough. There are individual high-yield bonds worth owning, but not the whole market.
Corporate decision making
Tax reform could have wide-ranging implications for corporate strategy. But in terms of what matters to the bond market, it comes down to whether the change in taxation results in less debt funding. The claim some make is that debt financing is effectively subsidized by allowing it to be written off as an expense. If something is subsidized, you are getting more of it than you otherwise would.
Here I'm highly skeptical that this will matter much at all. The vast majority of companies face much higher cost of equity funding vs. cost of debt funding. Take semiconductor company Micron Technology (MU) - Get Micron Technology, Inc. (MU) Report . It has a cost of equity capital at 13.2%. On an after-tax basis, the company's average cost of debt capital is 2.9%. Even if we assumed a statutory marginal rate of 35%, Micron's cost of debt would only be around 4% if it couldn't write anything off. That's still far lower than 13.2% cost of equity.
Even more damning is the fact that Micron's effective tax rate is just 6%. Average tax rates aren't the same as marginal rates, but we can safely assume Micron's marginal rate is way lower than 35%. So the delta between today's tax regime and Paul Ryan's (just in terms of cost of debt) is probably minimal. In other words, Micron would probably be making the same balance sheet decisions regardless.
This could have a material impact on companies doing LBOs or similar transactions. Some of those transactions wouldn't work at all if the net cost of debt were higher. But this has been a pretty small part of bond issuance the last few years. I could see there being some impacts on niche parts of the market, such as the aforementioned bank loans or the BDC (business development companies) space. But even there, I think the effect on issuance would be long-term and pretty minor.
We should be cautious on how much we actively bet on any particular tax regime. There is a lot of politics yet to play out on this. In the case of high-yield bonds, I think valuation is a good enough reason to get out, and this tax-related risk is just one more reason. I would be very careful chasing any company that is being driven up on hopes of a more favorable tax regime. We just don't know what exactly is coming.
At the time of publication, Graff was long VZ and MU bonds, although positions may change at any time.