Tax Reform: A Year-End Bonus for Fixed Income?
How the new tax legislation will impact the US investment grade market
Despite the near non-stop drama of the legislative process, we ended December with the Tax Cut and Jobs Act of 2017 being signed into law. What does this mean for fixed income investors? In my opinion, the news is overwhelmingly positive for the US investment grade market; here are four reasons why.
1. The tax code changes are expected to result in additional corporate deleveraging (and improved fundamentals) over the next several years as companies issue less debt.
There are two main reasons why I believe we will see reduced corporate issuance in the near to medium term. The first is the new repatriation tax. US corporations have trillions of dollars that were trapped overseas1 because they didn’t want to pay the 35% tax to bring that money back into the US. The new legislation creates a repatriation tax of 15.5% on liquid assets and 8% on illiquid assets. With the rates now so much lower, I believe companies will increasingly use their own overseas cash (rather than raising funds through bond issuance) to fund dividends and stock buybacks. The net result would be a significant drop in the supply of bonds going forward, possibly as much as $100 billion to $150 billion per year by my calculations.
The second supporting factor is the lower corporate tax rate. The reduction to 21% (from 35%) has actually raised the cost of debt. Companies can deduct interest expense to lower their tax rate, so they are incentivized to carry some debt. However, a lower tax rate makes the deduction less valuable, and I believe that over time companies will respond with less leverage. This would be positive from a fundamental standpoint (as companies carry less debt) and also from a technical standpoint (as companies issue fewer bonds, reducing the supply). While 2017 US investment grade issuance set a record at $1.423 trillion (up 5% over the previous year2), demand still outpaced supply, driving spreads to Treasuries tighter. At Invesco Fixed Income, we expect supply to decline in 2018 for the first time since 2010, and if we are correct, spreads should continue to grind tighter and challenge the very narrow spread levels that we saw in 2005.
2. The recent changes also make companies less inclined to take on more debt due to limits on interest deductibility.
In addition to lowering corporate tax rates, the new tax legislation places limits on interest deductibility where there were none previously. This is another general disincentive for adding balance sheet leverage. The law specifies that companies can now only deduct interest of up to 30% of EBITDA (earnings before interest, taxes, depreciation and amortization) for four years and then 30% of earnings before interest and taxes thereafter. Another impact of this change is that the risk of a corporate takeover via leveraged buyout has now declined materially. Since private equity firms would not be able to fully deduct their interest expense, these deals have suddenly become prohibitively expensive.
3. With the final tax code changes in place, merger and acquisition (M&A) activity is expected to increase, but transactions will likely be funded with more equity than debt.
The forward calendar for M&A transactions is very light with only a few deals in the pipeline for early 2018. We expected this activity to pick up once the specifics of the tax legislation were known, and it has, with some large acquisitions recently announced. But we don’t believe this activity will lead to a massive increase in debt issuance for financing. Some of the recently announced deals will be 100% equity-funded or have a significant equity component. We expect companies to use less debt in M&A financing because:
- A lower tax rate means a lower deduction, which raises the cost of debt.
- Equity markets are at all-time highs, so fewer shares are required to complete stock transactions.
Increased regulatory scrutiny may also keep a lid on issuance. If a company chooses to finance an M&A deal with debt instead of equity, the timing of the debt issuance is likely to be delayed until a deal is 100% approved. A company prefunding a deal with debt runs the risk of paying months and months of extra interest while regulators debate its merits.
4. Central bank policy is expected to remain accommodative, supporting corporate bond performance.
The US Federal Reserve (Fed) is focused on economic growth to guide the pace of the balance sheet reductions that it announced in September. We expect ongoing US economic growth of around 2.75%, which should facilitate the continued unwinding of the Fed balance sheet to a level of $2.5 trillion to $3 trillion (from about $4.2 trillion today3). The Fed has said that interest rate hikes will be determined by the level of inflation, which remains low. Therefore, Invesco Fixed Income is forecasting only two hikes in 2018 (in March and June), followed by a pause for the remainder of the year as we expect a flat yield curve and continued lack of inflation to become a concern for the Fed. The boost in gross domestic product from the new tax changes should be about 0.5%, in our view, which shouldn’t be overly inflationary. On the long end, we don’t see materially higher rates and are targeting the 10-year Treasury to end 2018 in the 2.6% to 2.75% range.
A Happy New Year for US investment grade bonds
In summary, we believe the new tax changes are very likely to unleash a flood of repatriated funds from overseas while suppressing issuance by raising the cost of debt financing. Given our accommodative Fed outlook, we predict another good year for the US investment grade market.
1 Source: CNBC.com, “Companies are holding a $2.6 trillion pile of cash overseas that’s still growing,” Nick Wells, April 28, 2017.
2 Source: Bloomberg L.P., data as of Jan. 3, 2018.
3 Source: Federal Reserve Bank of New York, System Open Market Account Holdings, data as of Jan. 3, 2018.
Matt Brill, CFA
Senior Portfolio Manager
Matt Brill is a Senior Portfolio Manager for Invesco Fixed Income. He is responsible for implementing investment grade credit strategies across the fixed income platform.
Prior to joining Invesco in 2013, Mr. Brill was a portfolio manager and vice president at ING Investment Management, where he specialized in investment grade credit and commercial mortgage-backed securities. Prior to that he was a portfolio analyst at Wells Real Estate Funds. He entered the industry in 2002.
Mr. Brill earned a BA degree in economics at Washington and Lee University. He is a Chartered Financial Analyst® (CFA) charterholder.
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Tax reform: A year-end bonus for fixed income? by Invesco