Republican radicalism: The implications of US tax reform for credit investors

A major question facing credit investors over the next year is the fate of US tax reform. The House of Representatives and Senate have both released their sweeping tax reform packages in recent weeks. But uncertainties remain as both chambers must reconcile their differences. As the year-end deadline to reform the US tax system approaches, we assess how proposed changes in interest tax deductibility could have far-reaching implications for credit markets.

Congressional Republicans have taken important steps in recent weeks toward the biggest overhaul of the US tax system since the 1980s. The House of Representatives passed its tax bill earlier this month. And last week, the Senate voted 51-49 to pass its version of the tax reform bill.

But there are sharp differences between the two proposed bills and reconciling them will be challenging for both chambers. As such, it remains uncertain whether they can meet President Trump’s year-end deadline.

One particular proposal that could significantly impact credit investors has come from the House of Representatives. It wants to cap the tax deductibility of interest payments exceeding 30% of a company’s earnings before interest, tax, depreciation and amortisation (EBITDA). In contrast, the Senate proposes limiting it to 30% of pre-tax net income.

Going global

The implications of the proposed US tax reform are far-reaching. And although the outcome is still uncertain, it is important for credit investors to assess the prospective tax code, particularly the proposed changes in interest tax deductibility. Here’s why:

1. Lower tax deductibility will affect the optimal leverage for US corporates as debt becomes a more “expensive” source of capital. This might lead to lower US corporate debt issuance.
2. The proposed changes to the US tax code are likely to encourage multinational US companies to issue debt in more favourable jurisdictions than the US and offset their foreign earnings with interest expenses. This will further boost the Reverse Yankees market – corporate bonds issued in Europe by US companies. For investors with the experience to exploit them, Reverse Yankees represent an attractive source of opportunity¹.

Figure 1. Tax reform should sustain greater Reverse Yankee issuance

Source: Hermes Credit, Bloomberg as at November 2017. *Based on US country risk issues in EUR currency

3. It could increase the divide in the credit spectrum between low- and high-rated companies. Issuers in the crossover space that are well within the proposed 30% cap might consider improving their interest/EBITDA ratio in preparation for a potential market downturn and subsequent drop in EBITDA. However, the extent of the adjustment that issuers make will depend on the cyclicality of their business and how conservative they choose to be.

Taxing the high-yield market
As aforementioned, the planned provision would impact high-yield issuers more than their investment-grade counterparts – particularly those at the lower end of the ratings spectrum within the high-yield universe. That’s because lower-rated companies have higher interest tax expenses as a percentage of their EBITDA.

The majority of CCC rated issuers will be affected by the proposal, while only a small proportion of BB rated firms will exceed the proposed 30% limit. Notably, more than half of the US high-yield market is made up of B and CCC rated firms² (See figure 2). But how will the proposed tax overhaul impact these companies?

• Lower-rated firms’ free cash flow generation will be weaker, in absolute terms and relative to higher-quality names, due to the higher tax bill. In turn, this will affect their valuations as investors will require a higher risk premium to invest in them.
• The impact on free cash flow will be exacerbated in a down cycle. That’s because EBITDA falls rapidly in a downturn and free cash flow is impacted by lower tax deductibility. As a result, this will affect valuation multiples in restructuring and bankruptcy situations, forcing down recovery rates in an already damaged market³. These effects will ultimately drive the spread between lower- and higher-rated credits wider.

Figure 2: Over half of the US high yield market could be impacted by the proposed tax reforms

Source: Hermes Credit and ICE BAML Indices as at November 2017

Shaking the foundations
Companies that rely heavily on debt financing, such as homebuilders, will be hardest hit by the proposed changes. Furthermore, other provisions within the proposed tax code will also negatively impact homebuilders, including plans to:

• deduct mortgage interest on principal residences only;
• eliminate the deduction on home equity;
• reduce deductibility of real property taxes; and
• cut the interest deductibility to maximum indebtedness of $500,000.

The proposed tax changes, together with an environment of rising interest rates, are likely to reduce demand for house purchases. And many potential consumers will choose to rent due to affordability challenges.

From a relative value point of view, US homebuilders are trading near three-year tights and are more than a standard deviation inside their historical ratio to the US high index.  As such, we are cautious on the homebuilding sector, particularly KB Homes, as it is highly levered compared to its peers and it has exposure to first-time buyers – the market segment most sensitive to house-price affordability.

It also generates a large portion of its revenues from California – a state that is expected to be hardest hit by the proposed tax changes due to the proposal to eliminate deductions that benefit taxpayers and as it has a high number of second homes. As a result, we like the 2v5 steepener trade, going long KB Homes credit default swap (CDS) two years forward and buying protection at the 5-year point.

Figure 3: US Homebuilders are trading near their historical tights

Source: Hermes Credit, Bloomberg as at November 2017

Positioning for a ‘game-changer’
As we move towards the year-end deadline for tax reform, it is important that credit investors position themselves for the most radical change to the US tax code since the Ronald Reagan era.

Taking the proposed House of Representatives tax package into account, we prefer higher quality names to lower rated companies and remain cautious on the homebuilding sector.

Investors should also take a closer look at the Reverse Yankee market and familiarise themselves with cross-currency spreads⁴, as the number of multinational US companies issuing debt outside the US continues to grow.

Republicans are brandishing the tax bill a “game-changer” for the US economy⁵. But until the House and Senate bridge their differences, the fate of US tax reform remains unclear. However there is one certainty as obvious as taxes themselves: the impact of the proposed US interest tax deductibility changes will be felt strongly in credit markets. 

¹ To read more on this subject, see “Trump tax changes to march Reverse Yankee bonds forward,” published by Hermes as at February 2017.

² Based on the composition of the ICE BAML US High Yield Non-Financial Constrained Index (H0NF)

³ Junk bonds’ risk-return profile has been permanently damaged Hermes Credit for Financial Times as of May 2017.

⁴ “Trump tax changes to march Reverse Yankee bonds forward,” published by Hermes as at February 2017.

⁵ “House speaker Paul Ryan on tax reform: ‘We really can get this done this year’,” published by CNBC as at September 2017.