Trump’s relationship with the corporate market got off to a rocky start when his Taj Mahal casino declared bankruptcy in 1991. It was a messy and contentious affair that received a lot of press – sounds familiar! Fast forward 25 years and it appears many of the tax and economic reforms proposed by the Trump administration may actually be quite good for the corporate bond market.
Tax reform could reduce corporate leverage over time and lead to a safer and less volatile corporate bond market, analysis shows. Let’s unpack this argument. When the corporate tax rate is high and interest expense is deductible, debt becomes a very cheap way to finance a business – debt is actually subsidized by the tax code whereas equity is not. For example, a company that issues debt with a 5% coupon and pays 35% in taxes has a 3.25% after tax cost of debt. If the tax rate is lowered to 20% the after-tax cost rises to 4.0%. All MBA students, CFOs and boards of directors know debt is a cheap way to finance a company, and that one of the quickest and easiest ways to increase the stock price is to lever up a company’s balance sheet. Over the past generation we have seen corporations shift their capital structure to a greater emphasis on debt. This makes sense as companies are run for the benefit of shareholders, not for the benefit of bondholders.
If corporate tax rates are reduced and/or deductibility of interest on debt is reduced, the relative cost of debt goes up and debt becomes less attractive. Research indicates there is a relationship between tax rates, interest deductibility and leverage; the lower the tax rate and the less interest deductibility, the lower the leverage.
Leverage at corporations should also be reduced if companies pay less in taxes and increase their income. If earnings increase there is less incentive to engage in debt related financial engineering, so the argument goes. Stronger companies have less need to engineer earnings and companies with less leverage and high earnings make for stronger borrowers.
Corporate America has been leveraging itself for the last generation, and changes in the tax code will not result in immediate changes in behavior, but it would be nice to have a tailwind in the corporate market. Lower leverage can lead to tighter spreads and higher prices for corporate bonds. All good. We have come a long way since the Taj bankruptcy.
Source: Barclays Capital, The Bloomberg, The New York Times, Vanity Fair