The U.S. tax reform that was passed late last year will encourage leveraged companies to reduce their debt, and it could limit the number of leveraged buyouts going forward, says Nicholas Leach, vice-president of global fixed income at CIBC Asset Management.
While the Tax Cuts and Jobs Act of 2017—which reduced the corporate tax rate from 35% to 21%—should benefit all profitable companies, Leach says, there will be new limits on interest expense deductibility specific to high-yield companies.
“The way the new policy is designed, it should only impact those companies with interest coverage ratios less than 3.3 times,” says Leach, who manages the Renaissance High-Yield Bond Fund.
He estimates that will affect somewhere around 25% to 30% of the high-yield market.
“By limiting deductability of interest expense, it will actually incentivize those higher-levered companies to have a more efficient capital structure. That means they should be reducing debt,” he says.
Bringing debt down will take years, but it should eventually “raise the credit quality of the market as a whole,” he adds.
The shorter-term impact of the tax reforms is they should reduce the number of leveraged buyouts, Leach says: those buyouts typically use a lot of debt, which will be less attractive.
“We have seen in the past that a leveraged buyout craze can contribute to the credit cycle. This new tax policy could actually mitigate large swings in those credit cycles,” he says.
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