By Natalie Harrison
NEW YORK (IFR) - US corporate tax reform proposals are causing consternation among bond market players, who fear their implementation will drastically reduce issuance levels.
President Donald Trump and Republicans in the House of Representatives have plans to cut corporate tax rates, allow repatriation of cash stuck in overseas accounts, and eliminate companies’ ability to deduct debt interest expenses from tax – actions some think would hugely reduce companies’ current reliance on debt.
The biggest pain to corporates – and the bond bankers who serve them – would come from not being able to deduct debt interest expenses, a benefit given to US companies for almost a century.
"Eliminating the interest deduction would complicate tax reform and disrupt the capital markets," Richard Farley, a debt financing partner at Kramer Levin Naftalis & Frankel, told IFR.
The proposal to eliminate interest deductions is counter-intuitive, he said, as doing so would negate some of the benefits companies would see from a cut in the corporate tax rate.
House Republicans and Trump have said they intend to cut the corporate tax rate to 20% and 15%, respectively, from the current 35%.
"If you eliminate tax deductibility, corporates will show more pre-tax profits and pay more tax absent a rate reduction," said Farley.
"What would the administration really accomplish by this, that simply lowering the corporate rate less wouldn’t accomplish?"
The ability to take tax deductions on interest payments has spurred companies to load up on debt to fund capital expenditure, acquisitions, leveraged buyouts and share buybacks, among other things.
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.
If interest tax deduction is eliminated at the same time as corporate taxes are slashed to the 20% level envisaged by House Republicans, only companies with an interest coverage ratio of four times or higher would be better off, a report from Citigroup credit strategist Matt King said.
"This is fine for almost everything in investment grade – with average interest coverage of around 10 times – but exactly in line with the average for dollar high-yield," the report said.
The proposed changes could also further stymie leveraged buyout activity, which has remained in the doldrums ever since the financial crisis, as a higher effective cost of debt reduces returns on equity for highly leveraged companies, and for LBOs in particular.
Bank of America Merrill Lynch strategists reckon the elimination of interest tax deductibility would detract about 4% from S&P 500 earnings per share over time.
Domestic issuance volumes in the US could also drop if companies issue more debt in jurisdictions where debt interest tax deductibility remained.
"When it comes to multinational corporates with the ability to issue offshore, the unilateral removal of deductibility in the US seems likely to have a very clear effect: companies would have an incentive to pay down domestic bonds and loans and issue from their offshore affiliates instead," King’s report said.
NOT THAT BAD
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.
"The wait-and-see camp is big," said one head of bond syndicate. "There are not many borrowers that want to raise debt when it’s still unclear what will happen."
Of course, there is often a significant difference between what is proposed by politicians and what finally makes it to law. And many of the people that IFR spoke to said that the elimination of tax deductibility would be one of the most difficult aspects of the proposed tax reforms to push through.
"It is being regarded as a long shot," said John Duensing, deputy chief investment officer at Amundi Smith Breeden. "It’s a more difficult part to implement."
For example, the help offset the elimination of tax deductibility of interest, corporates could depreciate capex immediately, under the House proposal, rather than over the lifespan of the investment as it currently stands.
"That would likely benefit industrials more than financials because of investment in plant and machinery," said Duensing.
Others think it possible that tax deductibility of interest payments will be gradually reduced, rather than eliminated in one strike.
Observers note that Trump has at times called for a “reasonable cap” on interest expenses rather than their elimination - which would help soften the blow for businesses that have benefited from deductibility, including his own.
And even if tax deductibility is scrapped, the market may take time to adjust, with a shift toward lower leverage taking place over a relatively long time.
"The elimination of tax deductibility will not be the death knell for the corporate bond market all of a sudden," Matthew Minnetian, a portfolio manager at Alliance Bernstein, told IFR.
"We do think it will take longer to play out."
And if the economy continues to strengthen companies will continue to issue debt, he said – to finance investment and M&A and to refinance already large debt piles.
"I’d be very surprised to see capital structures change overnight, and if you look at the cost of debt versus the return on equity, the cost of debt is still very low."
If tax deductibility is eliminated, there could also be the possibility of “grandfathering”, which would mean the changes only apply to new debt.
"If that happens, you could see issuers come to market to front-run the changes," said the head of a US bond syndicate.
(Reporting by Natalie Harrison; Editing by Shankar Ramakrishnan, Jack Doran and Matthew Davies)