The primary intent of the proposed tax reform legislation, as we understand it, is to stimulate the economy and increase jobs. We are not sure legislators also intend to make the world safer for corporate bondholders, but that is the way we see tax regulation playing out over the next few years. We see a number of ways a lower proposed corporate tax rate will help bondholders, some obvious and others far less so.
First, and most obvious, it is estimated that earnings per share (EPS) of the S&P could go up around 5% due to reform after you take into account lower taxes, interest deductibility, cash repatriation impacts and the effects of stock buybacks. We anticipate that most of the increase in earnings and repatriated funds will go into buybacks and higher dividends, yet it is easy to see that if a company is making more money its ability to service and repay its debts is enhanced.
Second, capping interest deductibility as a percent of EBIT or EBITDA should immediately encourage lower leverage levels in mergers and acquisitions, leverage buyouts and in the lowest tier of high yield issuers. Curbing some of these excesses can certainly help reduce corporate defaults over time, as well as loan losses in the banking sector, when the credit cycle turns.
Third, and least obvious, a lower tax rate should generally lower all corporate leverage, which has been on an uptrend for, well, practically forever. Here is how this works: when the corporate tax rate is high and interest expense is deductible, debt becomes an attractive way to finance as it is subsidized by the tax code where equity is not. For example, if a company issues debt with a 5% coupon and the company pays taxes at a rate of 35%, the after tax cost of debt is 3.25%. If the tax rate is lowered to 20% the after-tax cost rises to 4.0%. Some street analysts anticipate corporate leverage could go down by as much as 25% over the course of a decade with a 20% corporate tax rate. Looking around the world there is a strong statistical correlation between corporate tax rates and leverage, yet any prediction of this sort is more art than science.
As we know, most unintended consequences seem to be negative, and we may yet discover a problem for corporate bondholders in the enactment of tax reform. But at this time our analysis points to what is likely an unintended silver lining.
Source: BofAML, Barclays, The Financial Times, Bloomberg and SNWAM bullets: Trump, Tax Reform and the Impact on Corporates January 2017 and Less Leverage – Its Practically Un-American! March 2017.