Tax reform: Lower corporate rate seen as net positive for investors
January 11, 2018
The US tax reform bill is now officially on the books, signed into law by President Trump in late December. Some key provisions of the law — such as the significant reduction in the corporate tax rate, multinational companies becoming subject to a territorial tax system, and new provisions regarding income and deductibility — are likely to have downstream effects for investors. Several of our investment teams have provided a first look at how tax reform may affect specific areas of equity and fixed income investing.
Fixed income: US investment grade credit
- Wayne Anglace, Senior Portfolio Manager
- Kashif Ishaq, Head of Corporate Bond Trading
- William Stitzer, Assistant Portfolio Manager
- Michael Wildstein, Senior Portfolio Manager
We view the new tax law as a clear benefit for US investment grade companies. By far, the largest driver from this legislation that could benefit US investment grade issuers is the lowering of the corporate tax rate to 21% from the current 35% rate. Analysts expect that lowering the corporate rate could account for approximately an 8% to 12% increase in net profits in 2018, which in turn could translate to earnings growth and incremental cash flow generation.
The advantages of a lower corporate tax rate will differ across the investment universe. For example, industries that already enjoy low tax rates for a variety of reasons — such as real estate investment trusts (REITs), many technology companies, regulated utilities, and energy companies in the exploration and production sector and integrated areas — would not see advantages to the same degree as companies that currently pay higher tax rates. Therefore, improvements to corporate credit metrics may vary across the universe of issuers.
Beyond lower corporate taxes, other factors in the new tax code should likely have a more muted effect on US investment grade credit issuers. For instance, the limiting of interest expense deductibility will not have a meaningful, adverse impact on the US investment grade market because the majority of investment grade issuers have interest coverage ratios that are well in excess of the level (3.3x) that would affect more highly levered issuers. Another factor positively affecting US investment grade issuers, but also to a lesser degree, is the full and immediate expensing of capital expenditures (capex) that is included in the legislation. Either in the form of higher depreciation expenses by the credit issuers themselves, or through increased sales if the issuers provide capital investment items to their customers, accelerated depreciation will have positive near-term effects on fundamentals.
Repatriation of cash and short-term investments held offshore (15.5% for cash and 8% for more illiquid assets) will likely have more of a varied effect on the credit metrics of US investment grade issuers. In one respect, credit profiles could improve if repatriated cash is used to de-lever and strengthen balance sheets. However, credit profiles could ultimately be weakened by management teams that choose to use their cash hoards for shareholder-friendly activities such as share buybacks and dividends. We would also note that front-end investment grade corporate bond prices could come under some pressure in 2018 if short-term investments held offshore are sold in order to repatriate cash.
Lastly, we see the territorial taxation included in the law (with companies being taxed for income outside the United States on a territorial system, albeit with certain restrictions) as more of a benign point in the new tax code. On a positive basis, this can allow US-based companies to invest overseas at low, foreign local tax rates and avoid paying US taxes. While this promotes investment for organic growth and potential increased profitability, the final use of any repatriated cash by the borrowers will ultimately determine the final outcome for creditors.
For 2018, strategists are predicting issuance in the US investment grade market will be down mid- to high-single digits, on a year-over-year percentage basis. While these estimates are predicated on repatriated cash supplanting new-issuance proceeds, interest deductibility expense being limited, and maturity schedules, we believe the final supply number for 2018 has the potential to grow from initial estimates if merger and acquisition activity picks up amid record-high equity market valuations and a now finalized tax scenario. Regardless, we do not expect issuance trends to be a material adverse factor on US investment grade credit valuations in 2018.
Ultimately, while healthier corporate fundamentals should support higher gross domestic product (GDP) growth and a more robust economy, we do not believe that the macro trends surrounding the new tax code will translate to outperformance for credit investors. Rather, we believe winners and losers in the US investment grade credit universe under the new tax code will be determined by in-depth research of corporate fundamentals and industry trends, along with understanding which management teams will alter their financial policies and capital structures in this reformed tax environment. Details and interpretations of the nascent legislation will undoubtedly emerge throughout 2018 and only careful scrutiny and discerning fundamental research will help determine outperformance in the US investment grade credit landscape.
Fixed income: High yield debt
- Adam Brown, Senior Portfolio Manager, Co-Head of High Yield
- John McCarthy, Senior Portfolio Manager, Co-Head of High Yield
With US tax reform a reality, we have better visibility into the possible effects on individual high yield debt issuers and the high yield fixed income market as a whole. Key data points that investors are closely monitoring include the positive benefits from the reduced corporate tax rate to 21% and increased capex deductibility. This must be combined with the offsetting negative effect from the limitation of interest deductibility to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA) and reduction in the amount of net operating losses (NOLs) that can be carried forward.
We believe that the majority of issuers within the high yield universe will be net beneficiaries of the new tax law, and that moving down the ratings spectrum, it becomes more likely that interest deductibility and NOL carryforwards will become a headwind in the future. It’s also important to note that beginning in 2022, the interest deductibility calculation will become more onerous as EBITDA will be replaced with earnings before interest and taxes (EBIT), which could influence future lower-quality new-issuance trends.
Generally speaking, higher-quality, less-levered credits with high capex and high current corporate tax rates stand to benefit the most. Lower quality companies with high debt levels, low capex, and large NOLs could see the most negative effects. In our view, the companies most negatively affected will be the riskier CCC-rated companies within the high yield universe. We believe that our underweight to CCC-rated companies, with a bias toward what we believe to be the higher-quality part of the CCC sector, leaves us well positioned for the potential impact of tax reform.
Despite the potential volatility the new tax bill may create, we do not believe any material sustainable spread moves will likely occur in the high yield market and, as a result, we do not plan to alter our expected default or return expectations for 2018.
Real estate investment trusts (REITs)
- Bob Zenouzi, Chief Investment Officer – Real Estate Securities and Income Solutions
The US tax reform legislation can be viewed as both a win for the real estate industry overall and a positive for REIT dividends.
Most corporations will only be able to deduct interest expense up to 30% of earnings (EBITDA). Most real estate concerns, however, will still be allowed to deduct up to 100% of their interest expenses. For REITs, an additional benefit is that investors can deduct 20% of dividend income, with the remainder deducted at the investor’s tax rate. Thus, REIT shareholders who currently pay taxes at the top marginal rate of 39.6% on dividends will see that effective rate drop to 29.6%.
Meanwhile, distributions of capital gains will still be taxed at 20%. This rate will continue to help make REIT dividends more attractive versus the double taxation that most corporate dividends are subject to.
As a side note, it’s worth remembering that REIT income is not only tax advantaged; it is also typically higher than what is generated by the broad equity market. At today’s levels, for instance, REITs are yielding 2 percentage points above the S&P 500® Index. We don’t place inordinate emphasis on after-tax yield when conducting valuation analysis, but it can be part of the overall conditions that could make REITs even more attractive as the new tax plan is implemented.
Small- and mid-cap value equity
- Christopher S. Beck, Chief Investment Officer – Small/Mid-Cap Value Equity
Small-cap companies, and to a lesser extent mid-cap companies, should generally benefit more from corporate tax law reform than their larger-cap peers. This is largely due to the fact that, on average, smaller companies have a relatively higher percentage of domestic exposure and therefore more domestic earnings that are taxed at a higher statutory rate. Certain sectors will see more of a benefit from the new tax reform law due to the majority of their business occurring in the US. We expect the financial services sector, certain segments of the consumer sector, and many transportation companies to see some of the biggest benefits from the corporate tax rates decreasing from 35% to 21%. Many of these companies could see earnings increase in the range of 20%. While most companies that we cover are still assessing the impact of tax reform, early commentary has been consistent with our views.
We will closely watch what the beneficiaries of tax reform choose to do with their newfound cash flow. Some larger companies have already announced one-time bonuses to employees and others have announced increases in capex. We believe that companies will most likely pursue a variety of options, including reinvesting in their businesses as well as returning cash to shareholders either through dividends or share buybacks. While it is possible that some of the positive effects could dissipate through competition, the overall impact should be decidedly positive for smaller-cap companies.
Small- and mid-cap growth equity
- Alex Ely, Chief Investment Officer – Small/Mid-Cap Growth Equity
Overall, we expect equity markets to benefit from tax reform. While not all of the corporate tax cut will flow through to earnings, a significant percentage will, and a significant amount is expected to be put into investment. Small-caps should benefit more as they generally have greater domestic exposure and higher tax rates. Some sectors such as retail, banking, manufacturing, and consumer services will likely be bigger beneficiaries, but overall, this type of fiscal stimulus is supportive across almost all sectors.
In general, the equity markets have just begun to open up. Confidence is improving from Main Street to the boardroom. People are taking action, trends are gaining in fundamental momentum. Lower taxes for corporations will feed this momentum. Active growth strategies are well positioned, in our view, to benefit from what we believe will be continued strength in the economy and in the markets.
Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.
REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations. A REIT fund’s tax status as a regulated investment company could be jeopardized if it holds real estate directly, as a result of defaults, or receives rental income from real estate holdings.
Capital expenditures (capex) are funds used by a company to acquire, upgrade, or maintain physical assets such as property, buildings, or equipment.
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The views expressed represent the Managers' assessment of the market environment as of January 2018, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Managers' views.
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