Why tax-bill fears may be one big contributing factor in junk bond slump

11/10/17 05:01 PM EST

By Sunny Oh

So-called high-yield issuers have plenty to lose under GOP tax plan

The recent selloff seen in high-yield bonds, or popularly known as junk debt, may partly be fueled by worries that the coming tax plan will cap the amount of interest payments eligible to be deducted from taxable earnings.

If a version of the tax bill is passed, which includes such a stipulation, analysts say junk bonds would prove the biggest losers as companies that issue high-interest debt tend to have the most debt-laden balance sheets. As Republicans make strides toward overhauling the U.S. tax code, the high-yield bond market has come under pressure.

"We're getting indications from both the House and the Senate that they intend to limit or do away with interest deductions, which is putting highly levered companies at a disadvantage. Their ability to deduct interest would be limited and affect operating metrics," said Jody Lurie, a corporate credit analyst with Janney Montgomery Scott.

See: Why stock-market investors should be worried about the junk-bond market (http://www.marketwatch.com/story/why-stock-market-investors-should-be-worried-about-the-junk-bond-market-2017-11-10)

The House Ways and Means Committee called for capping the amount of interest expenses that corporations would be allowed to deduct from taxable profit at 30%. Strategists from Bank of Merrill Lynch calculated that under the initial provision, around 40% of junk bond issuers would be directly affected, compared with 4.6% of high-grade bond issuers.

Prices for high-yield debt have fallen steeply. Bond prices and yields move in the opposite direction. The Bank of America Merrill Lynch U.S. high-yield option-adjusted spread (https://fred.stlouisfed.org/series/BAMLH0A0HYM2), the premium investors demand for buying a high-yield bond, compared with the perceived safety of Treasurys, has widened more than 40 basis points to 3.79% on Thursday, from 3.38% on Oct. 24 when the junk bond market neared the tightest spreads seen since the financial crisis.

Strategists at BAML said most of the selling has been concentrated in a few telecoms companies, including so-called legacy wireline businesses, that suffer from business models overshadowed by the rise of mobile phones and wireless internet.

"Only a dozen names in the index have been responsible for half of [high-yield] index widening so far this week," they said, also citing the collapse of Sprint's (http://www.marketwatch.com/story/how-end-of-sprint-and-t-mobiles-merger-talks-is-impacting-wireless-business-2017-11-06)(S) merger with T-Mobile (http://www.marketwatch.com/story/how-end-of-sprint-and-t-mobiles-merger-talks-is-impacting-wireless-business-2017-11-06)(TMUS) and the credit downgrade of TEVA (http://www.marketwatch.com/story/tevas-stock-and-bonds-plummet-after-fitch-downgrade-to-junk-2017-11-07)(TEVA) pharmaceuticals (http://www.marketwatch.com/story/tevas-stock-and-bonds-plummet-after-fitch-downgrade-to-junk-2017-11-07).

Analysts from UBS reported that around 70% of the telecom firms that issue high-yield paper sported an interest-coverage ratio of less than 2 as of Oct. 25. 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 its debt in a timely fashion. A higher ratio implies that the company's finances are healthy. A majority of the industry would run afoul of the new rules, analysts say.

Because many high-yield issuers don't generate a profit, with no taxable earnings to deduct, they would get "none of the upside, but all of the downside," said Dominic Pappalardo, director of the taxable portfolio management team at McDonnell Investment Management. "[High-yield issuers] are only going to get hit with additional interest costs."

But analysts said the recent pullback shouldn't be reason to panic. High-yield credit spreads stood at 2.71% at the year's start. In other words, investors in this sector are still holding on to hefty gains.

"From the spread perspective, we're still lower than the beginning of the year," said Marvin Loh, senior fixed-income strategist for BNY Mellon.

However, he said asset valuations considered rich and tighter credit spreads, suggests that a selloff sooner or later was in the cards. It is a view which has gained some attention among market participants.

"Now we're at this point, where the risk-reward trade-off isn't balanced. Investors are considering if the risks they're taking are warranted, and whether they should take profit off the table before market liquidity dries up heading into the end of the year," said Lurie. Trading for corporate bonds tends to fall toward the holiday months as the holidays approach, meaning fewer prospective buyers.

Also check out: Tesla's junk bonds are trading underwater--and it could spell trouble for Elon Musk (http://www.marketwatch.com/story/teslas-junk-bonds-are-trading-under-water-and-it-could-spell-trouble-for-elon-musk-2017-11-10)

-Sunny Oh; 415-439-6400; AskNewswires@dowjones.com

 

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11-10-17 1701ET

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