The recent tax reform package signed into law for 2018 is an overwhelmingly positive development for U.S. corporations. The tax package promotes capital investment through lower statutory cash tax rates and accelerated depreciation for capital expenditures made in the United States.

The headline 21% tax rate is applicable for adjusted domestic earnings. However, new limitations on the amount of interest expense deduction allowed in calculating adjusted earnings will limit the benefits some companies receive from the lower headline tax rate and may actually penalize certain U.S. corporations in the coming years.

 

Starting in 2018, the tax law places a 30% cap on allowable interest expense deductions relative to EBITDA. This cap translates to an interest coverage ratio in excess of 3.33x for all borrowers. Any disallowed interest expense (the amount of interest in excess of the cap) will be allowed to be carried forward indefinitely to be recognized in future years should the company fall below the cap. The 30% limitation becomes even more restrictive in 2022, as the earnings metric to which the cap applies will migrate from EBITDA to a more conservative measure of operating earnings, EBIT. Highly levered, capital intensive businesses who recognize large non-cash depreciation expenses within the high yield space are undoubtedly taking notice. For those companies with the wherewithal, we’d expect a push toward increasing interest expense coverage in the coming years through a reduction of debt and a focus on investment that is immediately accretive to operating profits. This is a positive development for creditors in higher quality junk, as companies may de-lever more quickly than previously expected in order to optimize their debt levels under the new tax law. However, this path toward deleverage will not be realized by all heavily indebted companies.

 

The day of reckoning for companies with more troubled balance sheets and weaker operating fundamentals may come sooner than expected. Companies with large amounts of debt and insufficient operating earnings will be unable to deduct all of the interest expense the issuer pays to meet financial obligations. And as secularly challenged businesses see continued erosion in their earnings, the cap on interest deduction will only become more punitive. Investors are already beginning to segment the potential winners and losers within the high yield market as we started to see bonds from secularly challenged industries and highly levered balance sheets sell off drastically in the past few months. The high yield bond market continues to behave more like a “market of bonds” rather than a cohesive “bond market.”

 

In recent years, the majority of high yield issuers have shifted toward higher quality, less levered balance sheets despite low overall rates and attractive conditions for financing. These companies continue to trade with low risk premiums reflective of their stronger relative position within the marketplace under the new tax code. Many of the lower quality and distressed credits in the market are not there by choice but as a result of poorly executed acquisitions, weak operating fundamentals, broken business models and in some cases a combination of all of these factors. Following the passage of the recent tax reform package, these companies now have an even more precarious outlook.

 

For weaker corporate credits, restructuring is often a choice rather than a decision forced on them by creditors. Company boards strategically declare bankruptcy or renegotiate debts in order to force discussions with lenders that otherwise could drag on for years to come. Such bankruptcy proceedings can be in the best interest of the company in the longer term as they can recapitalize and shed debt that could have otherwise never been paid back. It is possible that one outcome of the tax reform is a wave of corporate restructurings among weaker U.S. corporations. The high yield index at large may see a spike in defaults in the coming years as companies that would have likely been forced to restructure later under the prior tax regime choose to accept their fate sooner and renegotiate more favorable terms that will create a greater degree of clarity for all parties. Investors should expect a rockier road in the coming years for many stressed junk credits. The differentiation among winners and losers will weigh on the performance of many issuers in the high yield market and heightens the risks associated with passively investing in a broad high yield index. The new tax code will only accelerate the market’s determination of the winners and losers within this idiosyncratic asset class.

The recent tax reform package signed into law for 2018 is an overwhelmingly positive development for U.S. corporations. The tax package promotes capital investment through lower statutory cash tax rates and accelerated depreciation for capital expenditures made in the United States.

The headline 21% tax rate is applicable for adjusted domestic earnings. However, new limitations on the amount of interest expense deduction allowed in calculating adjusted earnings will limit the benefits some companies receive from the lower headline tax rate and may actually penalize certain U.S. corporations in the coming years.

 

Starting in 2018, the tax law places a 30% cap on allowable interest expense deductions relative to EBITDA. This cap translates to an interest coverage ratio in excess of 3.33x for all borrowers. Any disallowed interest expense (the amount of interest in excess of the cap) will be allowed to be carried forward indefinitely to be recognized in future years should the company fall below the cap. The 30% limitation becomes even more restrictive in 2022, as the earnings metric to which the cap applies will migrate from EBITDA to a more conservative measure of operating earnings, EBIT. Highly levered, capital intensive businesses who recognize large non-cash depreciation expenses within the high yield space are undoubtedly taking notice. For those companies with the wherewithal, we’d expect a push toward increasing interest expense coverage in the coming years through a reduction of debt and a focus on investment that is immediately accretive to operating profits. This is a positive development for creditors in higher quality junk, as companies may de-lever more quickly than previously expected in order to optimize their debt levels under the new tax law. However, this path toward deleverage will not be realized by all heavily indebted companies.

 

The day of reckoning for companies with more troubled balance sheets and weaker operating fundamentals may come sooner than expected. Companies with large amounts of debt and insufficient operating earnings will be unable to deduct all of the interest expense the issuer pays to meet financial obligations. And as secularly challenged businesses see continued erosion in their earnings, the cap on interest deduction will only become more punitive. Investors are already beginning to segment the potential winners and losers within the high yield market as we started to see bonds from secularly challenged industries and highly levered balance sheets sell off drastically in the past few months. The high yield bond market continues to behave more like a “market of bonds” rather than a cohesive “bond market.”

 

In recent years, the majority of high yield issuers have shifted toward higher quality, less levered balance sheets despite low overall rates and attractive conditions for financing. These companies continue to trade with low risk premiums reflective of their stronger relative position within the marketplace under the new tax code. Many of the lower quality and distressed credits in the market are not there by choice but as a result of poorly executed acquisitions, weak operating fundamentals, broken business models and in some cases a combination of all of these factors. Following the passage of the recent tax reform package, these companies now have an even more precarious outlook.

 

For weaker corporate credits, restructuring is often a choice rather than a decision forced on them by creditors. Company boards strategically declare bankruptcy or renegotiate debts in order to force discussions with lenders that otherwise could drag on for years to come. Such bankruptcy proceedings can be in the best interest of the company in the longer term as they can recapitalize and shed debt that could have otherwise never been paid back. It is possible that one outcome of the tax reform is a wave of corporate restructurings among weaker U.S. corporations. The high yield index at large may see a spike in defaults in the coming years as companies that would have likely been forced to restructure later under the prior tax regime choose to accept their fate sooner and renegotiate more favorable terms that will create a greater degree of clarity for all parties. Investors should expect a rockier road in the coming years for many stressed junk credits. The differentiation among winners and losers will weigh on the performance of many issuers in the high yield market and heightens the risks associated with passively investing in a broad high yield index. The new tax code will only accelerate the market’s determination of the winners and losers within this idiosyncratic asset class.

About the Author

Stephen Zurilla

Stephen Zurilla

Mr. Zurilla is a Portfolio Manager of Fixed Income and a member of the Investment Committee. Prior to his current role, Mr. Zurilla has served as a Research Analyst and Trader at ACM. As an analyst, Mr. Zurilla covered fixed...
About the Author

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