Is the New Tax Law Really a Tax Cut for High Yield Corporations?
First, Happy New Year to everyone out there! For the first chart of the week of the new year, I’ve taken a deeper look at the potential winners and losers for the high yield asset class as a result of the new tax law. U.S. High Yield (HY) has just finished another solid year with returns of approximately 7.5% for 2017 (as measured by the JPM U.S. HY Index). Credit spreads have tightened again, and defaults were lower again this past year. Both instances helped the total return of the asset class in 2017, but also set up 2018 as a year that may see lower total returns. With that said, some names will benefit from the new tax code, and others could be materially worse off. The new law introduces limits on interest deductibility but also lowers the corporate tax rate and allows for the ability to fully deduct capital expenditures (capex).
With the new tax law initially limiting interest deductibility to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization), the conservatively leveraged high yield credits will likely be able to benefit from the lower corporate tax rate. On the other hand, those credits that have large interest burdens relative to their earnings will be capped at how much interest expense they can deduct from their taxes, posing a serious headwind to their cash flow. Even after adjusting for the new lower corporate tax rate and the ability of corporations to fully deduct capex, the lowest rated credits may be at risk of further downgrades or even accelerated bankruptcies. As seen in this week’s chart of the week, the BB (higher rated high yield credits) issuers will be almost entirely positively impacted by the new tax code. Unfortunately, the already riskiest credits (CCC) will be mostly negatively impacted. This should cause investors in CCC-rated credits to invest carefully and selectively in 2018.
The potential for tax reform has been in the headlines since last year’s presidential election, and some of this news has been gradually priced into the HY market. We’ve seen some CCC-rated credits diverge from the higher quality names, even in an overall higher market. This could present some opportunities in 2018, as not all CCC-rated credits will be worse off, but there may be some that are already pricing in too high a probability of default.
The chart shows 75% of U.S. HY issuers are expected to be positively impacted by the new tax code. This could be a catalyst for credit spreads to continue to tighten and for defaults to remain low, resulting in another positive year of solid returns. With that said, be careful when investing in the CCC-rated names, as nearly 75% of them are expected to be negatively impacted. CCC-rated credits often have free cash flow at breakeven or even negative levels, and therefore any unexpected headwinds such as this tax reform could be the straw that breaks the camel’s back.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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