The tax bill passed in December made substantial changes to the tax code, both for individuals and for corporations. While the drop in individual tax rates grabbed many of the headlines, there were a handful of changes to the corporate tax code that could impact the corporate bond market, including:
- A drop in the corporate tax rate from 35% to 21%
- Lower taxes on profits repatriated from overseas
- Limits on interest deductions from corporate earnings
Overall, we believe the drop in the corporate tax rate should be a supporting factor for both the investment grade and high-yield corporate bond market. However the new limits on the amount of interest companies can deduct from their earnings could have a negative impact on certain parts of the high-yield bond market.
Lower corporate tax rate
Overall, we see the tax cut as a supporting factor for U.S. corporations and the corporate bond market as a whole, because the lower rate should free up cash flows for most bond issuers. That said, there’s no guarantee that cash will go toward repaying debt—many firms have already announced plans to boost their dividends or share repurchases, while others have announced intentions to increase their employees’ wages or have offered one-time bonuses. Regardless of what they do with the tax savings, we think the increased cash flows should make it easier for most firms to make timely interest and principal payments on their outstanding bonds.
Not all companies will reap the same benefits, however. While the corporate tax rate has been lowered, many firms already paid lower effective tax rates, thanks to various corporate deductions. According to Standard & Poor’s (S&P), issuers whose earnings come primarily from domestic sources may see lower effective rates as a result of the new law than companies that rely more on their overseas operations for earnings.1
Lower taxes on repatriation of overseas profits
The new law includes one-time repatriation taxes for overseas profits held in cash and cash equivalents of 15.5%, while profits held in less liquid assets will be taxed at a lower rate of 8%.
According to S&P, access to those funds could theoretically help mitigate default risk, though, again, there are no guarantees about how that cash will be put to use. In 2004, for example, Congress enacted a “tax holiday” under which corporations were permitted to bring foreign profits back to the U.S. at relatively low rates—the profits were taxed at just 5.25% instead of the normal 35% rate. However, most of the repatriated cash was returned to shareholders. S&P expects a similar dynamic this time, saying it expects “U.S. nonfinancial corporate issuers to distribute to shareholders a significant portion of overseas cash.”2
Even if most of the repatriated cash isn’t used to pay down debt, we still think it’s a supporting factor for the corporate bond market because it will free up cash that issuers could use to make interest and principal payments if need be. Keep in mind that bonds still rank senior to an issuer’s stock, so for companies facing financial stress, the ability to bring overseas cash home is a positive development.
Interest deduction limits
The new cap on interest deductions has received less attention in the press, but we believe this provision could have a negative effect on the lower-rated, riskiest corporate bond issuers.
Previously, there was no limit on the amount of interest companies could deduct from their earnings. The new law caps deductions at 30% of earnings before interest, taxes, depreciation and amortization (EBITDA). And beginning in 2022, that 30% limit will apply to earnings before interest and taxes (EBIT). That is less generous. Without the depreciation and amortization allowance, the amount of interest that can be deducted will likely decline even further. Why does this matter? Deducting interest expenses from earnings helps companies reduce their tax bills. By setting limits on interest deductions, firms with high interest expenses relative to their earnings could see reduced cash flows, all else being equal.
According to S&P, this change could be an issue for the high-yield market, while the effect on the investment grade market should be minimal. Among the corporate bonds S&P rates, only 0.7% of the investment grade issuers currently have interest expenses above the EBITDA limit, while just 8% have expenses that exceed the EBIT limit. Things look worse for the high-yield market: Almost half the issuers S&P rates have interest expenses of more than the 30% of EBITDA, while nearly three-quarters of the issuers have interest expenses above the EBIT limit.3 And keep in mind, the percentages shown for the EBIT thresholds below are based on the current state of S&P’s rated issuers and may be materially different when the switch to EBIT occurs in 2022.
Limits on interest deductions could have a greater impact on the high-yield market
Source: S&P Global Ratings. Based on three-year average forecasted data (2018-2020 projections), as of 12/1/2017. EBITDA: reported operating income before depreciation and amortization used as a proxy for earnings before interest, taxes, depreciation and amortizations. EBIT: reported earnings before interest and taxes.
Not all high-yield issuers are the same, of course. According to S&P, “the limits have a more pronounced effect on ‘highly leveraged’ companies with lower interest coverage and higher debt leverage ratios.”4
Leverage is a measure of debt relative to earnings—S&P’s calculations refer to an issuer’s debt relative to its EBITDA. All else being equal, a higher amount of leverage often means a greater risk of default, because earnings for such companies tend to be low relative to the amount of debt outstanding. Higher leverage usually leads to lower credit ratings.
As the chart below illustrates, issuers with the most leverage also have a greater likelihood of having interest expenses equivalent to 30% or more of their earnings. These issuers tend to have relatively low ratings as well, as credit quality generally declines as interest costs climb relative the issuer’s earnings. According to a recent report by Moody’s Investors Services, “the loss of the full deductibility of interest expense may be most apparent at ratings of B3 or lower.”5
So while the drop in the corporate tax rate should serve as a supporting factor for the corporate bond market, the limits on interest deductibility may actually negate those benefits for the some of the lower-rated, highly leveraged issuers.
Issuers with the most leverage could be most affected by the interest deduction cap
Source: S&P Global Ratings. Based on three-year average forecasted data (2018-2020 projections), as of 12/1/2017. Leverage: adjusted debt to EBITDA three-year forecasted average. EBITDA: reported operating income before depreciation and amortization used as a proxy for earnings before interest, taxes, depreciation and amortization.
What to do now
Watch the credit ratings of your corporate bond holdings and consider the potential benefits of moving up in quality. For investors who own high-yield corporate bonds today, either as individual holdings or through a fund, we think it makes sense to move up in quality, focusing more on the double and single B rated parts of the high-yield market, and reducing exposure to investments with CCC or below ratings, because they tend to have the most leverage. To put it into perspective, bonds rated CCC and below make up roughly 15% of the Bloomberg Barclays U.S. Corporate Bond Index. If the fund you own has more exposure than that, the manager may be taking undue risk.
Broadly speaking, we think changes to the corporate tax code are generally positive for the corporate bond market. Considering economic growth has been improving and corporate profits were on the rise even before the tax bill was passed, we think U.S. corporate issuers are generally in good shape.
However, we believe investors just aren’t being compensated with much additional yield for the additional risks in high-yield bonds. The relative yields that both investment-grade and high-yield corporate bonds offer relative to Treasuries are at post-financial crisis lows and are not that far off their all-time lows. And with our outlook for Treasury yields to move modestly higher this year, we think returns this year will likely be driven by coupon payments, not by price appreciation. Given this outlook, we think it makes sense for investors to maintain allocations to either investment grade or high-yield corporate bonds that are in line with their risk tolerance and long-term investing horizon.
1 Source: Standard and Poor’s, “U.S. Tax Reform: Why Lower Corporate Tax Rates May Not Lower Some Companies’ Tax Burden,” November 20, 2017.
2 Source: Standard and Poor’s, “U.S. Tax Reform: Preliminary Thoughts on Credit Implications for U.S. Nonfinancial Corporate and Infrastructure Issuers,” November 9, 2017.
3 Source: Standard and Poor’s, “U.S. Tax Reform: An Overall (But Uneven) Benefit for U.S. Corporate Credit Quality,” December 18, 2017.
5 Source: Moody’s Investors Services, “High-Yield Bond Issuance Thrives Despite Tax Law Changes,” Weekly Market Outlook, January 25, 2018. Using Moody’s rating scale, high-yield bonds are those rated below Ba1and below; the bottom of the scale is C. For the Ba, B, and Caa tiers, Moody’s also assigns a “1,” “2,” or “3” after each rating in order to further tier the ratings. A rating of B3 is at the low end of Moody’s ratings scale, and issues with such ratings are considered highly speculative.
What you can do next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.