Although many investors remain focused on the potential impact of U.S. tax reform on corporate earnings, we believe any change in tax policy can have an equally important effect on the price and supply of corporate credit. While the remainder of this piece will highlight this logic, our unambiguous takeaway is that we believe credit can continue to outperform low-risk assets over the next 12 to 18 months.

Financial Impact

As we explained previously, companies with high marginal tax rates may see the most significant effect on their earnings. However, in order to blunt the net revenue impact to the government, the Trump administration has also proposed that it may want to partially limit the tax deductibility of interest expenses. In our view, it is likely that this provision will be used as a bargaining chip with deficit hawks, as previous estimates found that interest deductibility costs the federal government $27 billion per year.1 Assuming a zero multiplier, this could generate nearly $270 billion in net revenue for the government over the ever important 10-year CBO scoring period. To potentially dampen this de facto tax increase on companies, they would also likely make capex fully deductible in the first year.2 

Under the current system of interest expense and capex deductibility, leverage has a negative tax rate. 

Turning back to Finance 100, firms should theoretically seek to maximize the efficiency of their capital structure by attempting to minimize their cost of capital. Given that corporations are currently able to deduct their interest expense, firms tend to deploy leverage in order to optimize their financing mix. Put another way, a company’s demand for debt should be proportional to the relative cost of equity and the firm’s benefit from the corporate debt tax shield. In the short run, tax cuts could increase earnings, increase free cash flow and stabilize P/E multiples. In the long run, tax cuts could diminish the benefit of the corporate debt tax shield, decrease leverage and shift corporations away from debt, thus increasing the demand/cost of equity. However, given that legacy debt would likely be grandfathered in,3 these changes would occur only as previously issued debt rolled off/matured. In our view, this implies that corporate debt issuance could decline and aggregate credit quality could improve.