The Tax Cuts and Jobs Act passed in late 2017 poses a few important changes that will affect the U.S. high yield bond market. Some key elements of the new tax plan include: the U.S. corporate tax rate will decline from 35% to 21%, the amount of interest expense that companies can deduct will be limited to 30% of EBITDA (30% of EBIT starting in 2021), and companies will gain the ability to fully write off capital expenditures in the year spent for at least the next five years. This blog discusses why we view these changes as a net positive for the high yield bond market, and how the new tax plan could impact BB and B rated issuers differently than more highly levered CCC rated issuers.
For most high yield companies, the benefit from a drop in the headline corporate tax rate outweighs the cost associated with decreased interest deductibility. This net positive effect for the high yield market becomes even more pronounced when one considers the potential for companies to increase their tax shields by fully deducting capital expenditures (capex). Since there are various moving parts to the tax plan, we performed a back-of-the-envelope calculation to determine the level of interest expense at which a hypothetical $100 million EBITDA company would earn the same profit under both the new and old tax regimes. In this analysis, we accounted for parts of the tax plan that we believe will have the largest effect on most high yield companies, namely the drop in the headline tax rate from 35% to 21% and the cap in interest rate deductibility at 30% of EBITDA. For simplicity, we ignored capex deductions and assumed zero values for depreciation and amortization. The following table shows our calculation using the income statement of our hypothetical company under both the old and new tax regimes:
As shown, we determined that when interest expense reaches 58% of EBITDA the company would generate the same profit under either the new or old tax regimes. In other words, when interest expense is 58% of EBITDA, a company becomes indifferent between the two tax regimes because the opposing effects of a drop in the headline tax rate and a loss in the full deductibility of interest expense cancel out. Importantly, this result also implies that when interest expense is less than 58% of EBITDA, a company would generate a higher profit under the new tax regime than under the old tax regime. By examining the holdings of our U.S. high yield bond exchange traded fund (ETF), which tracks the Solactive USD High Yield Corporates Total Market Index, we determined that most high yield companies would benefit from the new tax plan as they do not have interest expense to EBITDA ratios that exceed 58%3. In fact, it turns out that only about 10%4 of the publicly-traded issuers of debt held by our ETF (which corresponds to less than 15% of the total market value of debt within our ETF’s portfolio) have interest expense to EBITDA ratios that exceed the 58% threshold. Fortunately, this may mean that our high yield bond ETF has a relatively small exposure to issuers that are most likely to be negatively affected by the new tax regime.
Closer inspection reveals that by rating, the majority of CCC companies exceed the 58% threshold, while most BB and B rated issuers do not exceed the threshold. This may imply that highly-levered CCC companies could experience a larger wave of defaults than previously expected prior to the new tax plan. In contrast, less-levered BB and B rated issuers may experience upgrades as they could become more profitable under the new plan. Relatedly, if one were to divide the high yield market into two segments, one comprised of higher-rated higher-quality bonds and another comprised of lower-rated lower-quality bonds, the higher-rated segment of the market might perform better than the lower-rated segment of the market under the new tax regime. As such, investors may want to reevaluate how they gain exposure to the high yield market. On the one hand, investors might be interested in maintaining full exposure to the high yield market since most companies may benefit from the new tax plan. On the other hand, investors may desire to tilt their portfolios away from lower-rated high yield issuers and towards higher-rated high yield issuers. Combinations of various high yield bond ETFs may enable investors not only to maintain full exposure to the high yield market, but also to tilt their portfolios towards different segments of this market. Ultimately, this speaks to the ever improving access, transparency, and efficiency that ETFs bring to the historically opaque high yield bond market.
If you would like to receive future Xtrackers blog posts please subscribe
3. This observation and the 58% threshold assume no capex deductions, zero values for depreciation and amortization, and ignore any other company-specific effects of the new tax plan. 4. Not all issuers of debt held by our US high yield bond ETF are publicly traded. Statistics cited in this blog are approximate since they are based solely on the publicly-traded ultimate-parent companies associated with bonds held by the ETF.
All credit ratings referenced are using S&P's rating convention.