Markets & Economy

The Tax Cuts and Jobs Act is having a notable impact across wide swaths of the economy, and the fixed income market is no different. The bill’s key achievement of lowering the corporate tax rate is certainly a favorable outcome for a number of businesses and their investors. Smaller tax payments boost free cash flow, earnings, and the debt paying capacity of issuers. Yet, the new law also caps the tax deductibility of interest payments in what is likely to be a very unfavorable change for some, and particularly unsavory for certain high yield corporate bond issuers.

Similar to the tax deductibility of mortgage interest, corporations have long been able to fully deduct interest payments on corporate debt. Policymakers believed the tax advantage would incentivize debt-financed business investment such as factories, equipment, and other long-term projects. However, the popularity explosion of debt-financed stock buybacks has called into question the effectiveness of this policy.

“Many debt-laden businesses may pay more in taxes despite the new lower tax rate”

The new cap on corporate bond interest payments uses a calculation to place an upper limit on how much interest will now be deductible. Although the new tax code formula is complex and changes over time, the reality is that many debt-laden businesses may pay more in taxes despite the new lower tax rate, and the net effect could lead to corporations issuing fewer bonds.

Companies that are heavily financed by debt will be most adversely affected. These firms tend to be start-ups or struggling firms and often operate in capital-intensive industries such as telecommunications, industrials, and energy. The bonds of many of these heavily leveraged firms are often rated below investment grade (also known as high yield or junk bonds). These low rated securities often pay a far higher yield relative to investment grade issues and, when appropriate, can be a valuable asset in a portfolio.

The high yield bond market also plays a critical role in the financial system. The ability of many bond issuers to access the financial markets with high yield bond offerings helps drive the economy’s innovation engine, and some of them include well-known companies such as Tesla, Netflix, and Sprint.

As the new tax law begins to impact the fixed income markets, we believe corporate bond issuance will slow as high yield bond issuers become reluctant to add to their debt loads without the tax advantage. The rule change could lessen the ability or desire of firms to fund long-run capital expenditure projects, reducing business investment.

From an investment perspective, we view high quality, debt-light companies as well positioned, as they benefit from the lower corporate tax rate and are unlikely to hit the interest deductibility cap. Conversely, we would expect the corporate bonds of low quality, debt-burdened companies to relatively suffer. For those most severely impacted, borrowing costs may meaningfully increase to levels much higher than under the old system, and defaults may rise. For these reasons, we continue to focus on higher quality issues within the high yield fixed income space.