Could US Tax Reform Prolong the US Credit Cycle?
At 10 years and counting, the US credit cycle appears to be nearing an end. Could a sweeping rewrite of the tax code keep it alive a little longer? Maybe.
Credit cycles vary around the world and have distinct stages. During the expansionary period, easy access to credit helps boost earnings and prompts companies to take on debt. As those debt levels rise, so does credit risk. A rise in interest rates usually leads to lower asset values, causing lenders to get stingier. This typically leads to a period of contraction and balance-sheet repair and, eventually, a recovery phase. We are seeing this full cycle play out in the high-yield energy sector following the collapse in oil prices in 2015.
As the following display illustrates, many US assets, including investment-grade and high-yield corporate bonds, are nearing the contraction stage. That doesn’t mean the cycle will end tomorrow. But it will end, and with the Federal Reserve expected to tighten policy further in 2018, the end is probably getting closer.
Enter tax reform. Congressional Republicans’ comprehensive tax rewrite contains several key elements that will affect the US corporate bond market. These include capping the deductibility of interest, a lower corporate tax rate and a tax holiday for companies who repatriate overseas profits.
These elements and others will affect different companies in different ways, depending on how much debt they have and other variables. But taken together, they may end up reducing companies’ need to tap the bond market to finance things such as capital spending and share buybacks.
Congress appears to be on track to pass the bill this week. Here’s our take on a few of the possible outcomes for US corporate credit:
A Gentle Nudge to Reduce Debt
By lowering the corporate tax rate (from 35% to 21%) and capping deductibility of interest, the tax plan would raise the relative cost of debt versus equity. That should encourage companies to reduce their leverage. But don’t expect a sea change here. The reduction will probably be modest, since the after-tax cost of debt will remain low by most measures.