UPDATE: Companies rush to sell bonds to get ahead of tax plan, sparking 'carnage'
By Sunny Oh
U.S. high-grade issuers issue $33 billion of debt in the first three days of the week, twice as much as expected
As lawmakers haggle over the details of a Republican tax-cut plan, U.S. corporations aren't taking any chances.
U.S. corporations are rushing to issue debt amid uncertainty over tax legislation, including how much of their interest payments will be eligible to be deducted from taxable earnings. In October alone, high-grade issuance hit a monthly record of $131 billion.
Activity in the bond market heated up further after the tax proposal outlined by the House Ways and Means Committee called for capping the interest expenses businesses would be allowed to deduct at 30% of taxable profits, limiting how much companies could save on taxes by loading their balance sheets with debt.
"This week we've seen a tremendous amount of supply hitting the market. Corporations are trying to issue debt ahead of any tax changes taking place," said Dominic Pappalardo, director of the taxable-portfolio management team at McDonnell Investment Management.
Highly rated U.S. corporations issued around $33 billion in debt in the first three days of the week. Leading the way were the unexpected issues of $10 billion in debt by Oracle (http://www.marketwatch.com/story/oracle-tapping-corporate-bond-market-with-deal-that-could-total-10-billion-2017-11-07)(ORCL) (http://www.marketwatch.com/story/oracle-tapping-corporate-bond-market-with-deal-that-could-total-10-billion-2017-11-07)and $7 billion by Apple (http://www.marketwatch.com/story/apple-is-tapping-the-corporate-bond-market-with-a-deal-that-could-raise-7-billion-2017-11-06)(AAPL). That contributed to the $1.3 trillion of debt sold by creditworthy companies so far this year, which is on pace to exceed last year's total of $1.34 trillion, according to Dealogic.
See: How Trump's tax bill could help businesses--and lobbyists (http://www.marketwatch.com/story/how-the-trumps-tax-bill-will-help-businesses-and-lobbyists-2017-11-08)
The flood of fixed-income issuance has sparked "carnage," slamming corporate paper and widening credit spreads, said strategists at Bank of America Merrill Lynch (see chart below). An increase in issuance can drive prices lower as bond-buyers have a stronger hand in price negotiations.
The Bank of America Merrill Lynch U.S. Corporate BBB option-adjusted spread, a measure of how expensive investment-grade bonds are relative to safe U.S. government paper, has widened by six basis points (https://fred.stlouisfed.org/series/BAMLC0A4CBBB) since Oct. 27.
"Financial names are being punished a bit, they operate with the most leverage. It is likely they're the most heavily impacted because they rely on debt financing for their operations," Pappalardo said.
Bonds issued by banks and financial services firms have seen net outflows of $164.2 billion on Thursday, data from MarketAxxess shows. The credit spread for Morgan Stanley(MS) bonds set to mature in 2049 more than doubled to 0.60 percentage point on Thursday from 0.25 percentage point on Nov. 2.
The selling in the market for high-grade corporate debt surprised some observers as the initial tax proposal would have only affected a small group of companies. BAML estimated that only 4.6% of high-grade issuers would have been affected by the new limits on interest deductibility.
That's because, under the provision, companies wouldn't be allowed to deduct interest expenses once the interest coverage ratio, the proportion of taxable earnings on an Ebitda basis to annual interest payments, fell below 3.3.
Ebitda, or earnings before interest, taxes, depreciation and amortization, is commonly used as a measure of cash flow or operating performance, while the interest-coverage ratio serves as a gauge of a company's ability to pay back its creditors. A higher ratio implies that the company's finances are healthy.
The median high-grade issuer with a BBB rating, the lowest credit rung qualifying for investment-grade status, was nowhere near triggering that cap, with an interest-coverage ratio of 9.6, data from CreditSight shows.
The debt deals from Oracle and Apple sparked particular surprise among analysts. "Tech names like that, and other companies with significant amounts of overseas cash, in our view should do the opposite," wrote Hans Mikkelsen and Yunyi Zhang, analysts at Bank of America Merrill Lynch.
Flush with cash, tech companies were expected to scale back issuance and purchase back their high-interest debt issues from bondholders once limits on interest-deductibility took effect, they said. The initial provisions, if passed, would have reduced the tax benefits from keeping costly debt on their balance sheets.
That didn't stop Apple from selling bonds to finance its $300 billion shareholders reward program.
-Sunny Oh; 415-439-6400; AskNewswires@dowjones.com
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11-10-17 1445ETCopyright (c) 2017 Dow Jones & Company, Inc.