By Davide Scigliuzzo, Natalie Harrison and Shankar Ramakrishnan
NEW YORK (IFR) - Investors are likely to demand hefty premiums on any new bond deals that give companies leeway to buy the bonds back if changes in US tax law send the cost of that debt soaring.
U.S. President Donald Trump this week pledged a major announcement on U.S. tax policy in the weeks ahead, raising the specter of game-changing reforms to the national tax code.
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Bankers and issuers are already considering new bond language in the event that the US government tries to eliminate the tax-deductible status of interest payments, or changes the rules on repatriation.
But while companies may want flexibility to buy bonds back at a lower premium than has typically been the case, investors are unlikely to give up their prerogatives without a fight.
"Anyone can understand that if issuers' interest expense and net tax payment goes up, that is deleterious to their income statement," said Tom Murphy, head of investment-grade corporate bonds at Columbia Threadneedle Investments.
"But I am not going to be taking that risk for them."
Murphy and others believe the buyside would be granting companies a free option – and receiving little compensation – in return for bearing the risk of lost interest payments in future.
"Why should investors be left short a call option?" he told IFR. "It is not the investor's responsibility to accommodate [issuers] for potential tax-law changes."
Under the US code, companies have been allowed to deduct interest expense from taxes for nearly a century, and scrapping that benefit would make debt much more expensive.
In return, according to people familiar with the talks, banks and issuers are considering a carve-out to the make-whole premium specifically for tax reform, so that the cost of buying that debt back for the issuer would be less onerous.
The make-whole premium – the usual penalty when bonds are bought back well ahead of maturity – compensates investors for future income they had expected to receive for the full life of the bond.
Any bid to tweak it for tax reasons, however, would come at a time when investors have been pushing back on other bond covenants seen as overly friendly to issuers.
IT services company Change Healthcare was the latest borrower to try to convince investors – and fail – to weaken the protections of investors in case of early redemption.
"Change Healthcare is a good example," said one senior leveraged finance banker. "It's a darling of the market, but they couldn't get that equity claw done."
Columbia Threadneedle's Murphy said borrowers should not be trying to get round the make-whole premium, which offers higher payouts.
"The make-whole call is there for a reason," he said. "Why call out potential specific changes to tax laws as an exception?"
But other market participants said issuers might consider several ways to try to get round the make-whole provisions.
Companies with enough secured capacity could sell loans instead, which they can pay down with little or no charges.
Another option could be to increase the redemption price or offer a higher yield when the bond is priced.
"It would probably have to come at the standard par plus half or three-quarters of the coupon," one portfolio manager said of a hypothetical tax-related call option.
"Guys will not want to give up the upside."
With the Trump administration still in its infancy – not to mention a likely battle with opposition Democrats – the final shape of tax reform is not yet known.
And that is enough to keep some borrowers on the sidelines for now – if they have no immediate need to raise debt.
Credit card giant Visa has already said it will not sell bonds until there is greater clarity. Other companies are using short-term markets, such as commercial paper, to keep operations ticking along.
"It does make sense to start the discussion about these reforms," said one head of syndicate at a top Wall Street bank.
"But to come out with a structure now would be hasty – and probably expensive."
Some on the buyside who have been in talks with bankers believe the premiums companies may have to offer may not be too punitive, and they are keen to keep deal flow steady.
"It is a very reasonable thing for issuers to do," said Gershon Distenfeld, director of credit at Alliance Bernstein.
"It is much better to have that kind of discussion, as opposed to having the market paralyzed and people not wanting to issue."
Bankers said overall volumes would also be a factor to consider.
"What you don't want to see is the first deal going well, and then getting an avalanche," said a second leveraged finance banker.
"Investors won't be as accommodating then, as they'll be worried about a large part of their portfolio being taken out if the tax rules do change and issuers buy the debt back."
(Reporting by Davide Scigliuzzo, Natalie Harrison and Shankar Ramakrishnan; Editing by Marc Carnegie)