The excitement of the recently enacted Tax Cuts and Jobs Act (TCJA) of 2017 may have died down, but the benefits for corporate borrowers are only just beginning to be realized. With the largest change to the U.S. tax code in three decades now set in place, corporate management teams are hard at work trying to quantify the effects of the new laws as well as the subsequent changes necessary to optimize deductibility and cash flow. High yield companies, overall, stand to benefit from tax reform. However, not all issuers are treated equally and higher quality companies (those rated single-B and BB) stand to benefit the most.
Of all the tenants of the new tax bill, the following should have the largest influence on high yield credits:
1) Corporate tax rate cut from 35% to 21% (POSITIVE): Simple math, free cash flow should increase meaningfully and higher quality issuers with larger net incomes stand to benefit more. Bank of America estimates that U.S. high yield issuers (ex-financials, utilities, and REITs) paid $30bn in federal taxes in 2017 under the old tax regime . A lower statutory tax rate will provide a significant boost to discretionary free cash flow. Consider HCA Inc., the largest hospital operator in the high yield universe, the company publicly stated that tax reform will lead to a cash tax reduction in 2018 of $500mm – roughly equal to 25% of their 2017 free cash flow.
2) Interest expense deductibility (POSITIVE for high quality high yield INVESTORS): Limited to 30% of EBITDA with five years of carry-forward. A cap on interest deductibility will automatically shift the subsidy from debt to equity. As the after-tax cost of debt increases, corporations are less incentivized to increase leverage. Prudent corporate Treasurers will shift financial policies in favor of retiring debt organically through cash flow or equity issuance. Under this scenario, credit profiles (total leverage and interest coverage) will improve over time, leading to an upward migration in credit ratings across the high yield market, but more so for BB and single-B issuers. In fact, Barclay’s estimates that the combined effects of a lower corporate tax rate and caps on interest deductibility could lead higher quality corporates to cut leverage by as much as 25% . The graph below shows historical net leverage by rating cohort (ex-financials). Current BB leverage of 3.6x could fall to 2.5x -3.0x, putting it on par with median leverage in the BBB universe.
Why is this positive for high yield investors? Two reasons: (1) spread compression and (2) scarcity value. First, spread compression could be substantial as high yield issuers are upgraded to investment grade and lower quality high yield names migrate to BB. Second, over time, issuance could decline causing the market to shrink as corporate funding shifts to more tax efficient markets.
3) Accelerated Depreciation and NOL’s (NEUTRAL /POSITIVE): Capital expenditures on most short-lived capital assets can be deducted in full in year one. This would provide a material, albeit most-likely temporary, impact on an issuer’s tax bill. NOL’s (net operating losses) are now limited to 80% of annual taxable income, which is more restrictive than under the previous code, however they can be carried forward indefinitely.
4) Repatriation of earnings (NETRAL/POSITIVE): The tax on foreign cash and non-repatriated earnings is set at 15.5%. While positive, this is expected to have a more-muted effect in the domestic high yield market as only the larger, highest quality issuers have substantial overseas operations.
Overall, forgetting for one moment the inherent complexities of tax accounting at all levels, the majority of high yield companies are expected to benefit from tax reform. Given the current tax rate and leverage of BB and single-B rated issuers, we believe they stand to reap the largest rewards from the changes outlined above. While it will take companies time to interpret and implement some changes, the tax rate cut is immediate, and we believe this is the first step toward structural credit improvement in the high yield market.
 Bank of America Merrill Lynch: “Tax Reform Impact on Leveraged Finance,” 4 January 2018
 Barclay’s Capital: “A Tax on Leverage,” 13 January 2017