How low can they go? Weighing the outlook for credit spreads after tax reform

December’s Tax Cuts and Jobs Act was heralded as the most sweeping tax reform of the past 30 years, and for good reason. 

Marginal income-tax rates for individuals were reduced across the board, but the really big news was the corporate tax reform end of the bill: Federal corporate tax rates were chopped from 35% to 21%, making the U.S. rate much more competitive with those in the rest of the developed world.¹ Companies generally welcomed the change, but the question for fixed-income investors is whether the lower cost of doing business will have any material effect on the corporate debt market. 

Any way you look at them, credit spreads, which measure the incremental yield various bond sectors offer over U.S. Treasuries, are tight. As of December 31, 2017, U.S. high-yield debt was offering less than 400 basis points over Treasuries; investment-grade debt was offering only about 100 basis points.² While those figures don’t represent all-time lows—yet—they're clearly very tight by historical standards.

Spreads, by way of background, will fluctuate as investors’ willingness to take risk changes. The chance of a corporation defaulting on its debt is, in theory, always greater than the chance of the U.S. government defaulting. When investors perceive that risk to be low, spreads tend to tighten; when the risk appears greater, as it did in 2008 and 2009, spreads widen. 

Historical comparisons notwithstanding, the tightness of today’s spread levels isn't in itself evidence that they couldn’t compress further. In aggregate, the reduced tax burden on corporations will boost margins and lead to stronger fundamentals. That trend—on top of the fact that we’re still not seeing that much use of debt for mergers or acquisitions or aggressive expansion—suggests that spreads today ought to be tighter than average. 

One of the things we can say with certainty is that the tax reduction won’t affect all segments of the market equally. On average, companies in the financials, industrials, telecom, and consumer staples sectors all pay some of the highest effective income-tax rates; companies in energy, real estate, and materials generally pay the lowest. The benefits of tax reduction will, naturally, be more valuable to companies currently paying higher tax rates.

It’s also safe to say that companies will deploy their extra cash in a variety of ways, particularly those with cash reserves overseas that will be looking to repatriate funds under the new law. It’s one of the immutable laws of investing that equity, which doesn’t require interest payments, is a cheaper funding vehicle than debt—and with a new cap on the deductibility of interest expenses, that’s never been more true. It’s unlikely, then, with stocks hitting multiple all-time highs in 2017 and yields generally climbing over the past several months, that we’ll see companies issuing new debt to buy back shares of stock at the same pace that we did a year ago. 

With all of this in mind, we’re particularly cautious of CCC-rated companies, which have some of the weakest fundamentals in the corporate debt market. In our view, CCCs, which tend to use a significant portion of their income to cover debt interest payments, will essentially break even after trading lower-interest tax rates for less deductibility of interest.

The most attractive companies, in our view, will be those that offer a combination of attractive relative yields and strong fundamentals—companies that can deploy any newfound capital from the tax reform to grow their businesses and strengthen their competitive positions. Those companies aren’t always easy to identify, and our strategy in a market that offers few bargains is to take a highly selective, research-driven approach. 

1 Tax Policy Center, United States Congress, December 2017. 2 Bank of America Merrill Lynch (BofA ML) Global Research, as of December 2017.