A (Sort Of) Bullish Thesis

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by: The Heisenberg

Summary

Credit has been a favorite Heisenberg whipping boy.

If you own corporate bonds (and that includes the folks in corporate bond ETFs), you should stay abreast of the tax reform debate.

Perhaps the most important questions revolve around the proposed elimination of the deductibility of interest expense.

Is it bullish or bearish? That depends on how you look at things.

I've had a lot of fun beating up on corporate bonds, both investment grade (NYSEARCA:LQD) and high yield (NYSEARCA:HYG).

Apologies to those who are still long credit following what has been a truly monumental rally (i.e. mammoth spread compression) over the past 12 months.

By now, regular readers (and perhaps even casual passersby who might have stumbled upon some of the more popular posts like last week's blockbuster "This Trade Is Over. Done With. Kaput.") are likely familiar with my thesis.

Essentially there's a valuation component (laid out at length in the post linked above) and a fundamental component that rests on i) my contention that oil is unlikely to stage a sustainable rally from current levels and ii) the fact that both IG and HY are weighed down by a tremendous amount of leverage (see the charts below, IG in the top panes and HY at the bottom).

(Charts: Morgan Stanley)

One of the reasons that leverage is dangerous is that forthcoming tax reforms could see the deductibility of interest expense eliminated.

Intuitively, if you've issued a lot of debt, you really don't want to see the ability to deduct the interest on that debt go away. Well, as the leverage charts above suggest, corporate America has issued a lot of debt. Here, have a look:

(Charts: Goldman)

For every argument, there's invariably a counterargument just like for every buyer there's a seller. Of course that doesn't mean that the counterarguments to my short credit thesis are sound (you might say I'm not "buying" them), it just means that, to paraphrase Jim Cramer, "there's always a bull thesis somewhere."

The amusing thing about corporate credit and the interest expense deductibility issue is that tax reform can be used to justify both the bear and the bull case for credit as an asset class.

As I explained in "A Taxing Concern", removing the deductibility of interest expense effectively strips debt of its preferability in companies' capital structure. Indeed, as many on the Street and more than a few readers have pointed out, eliminating interest deductibility would essentially wipe away six decades of corporate finance theory. So this is no small matter.

For those who missed it, here is Goldman's analysis of the effect this change would have on corporates' weighted average cost of capital:

(Tables: Goldman)

Nothing fun about that, right?

Indeed, as Citi has shown, the interest coverage threshold beyond which this change would hit corporate bottom lines is about 4X. So HY is in an especially compromising position.

I don't want to go too far down the rabbit hole on the bear side of things (to mix animal metaphors) here because I've outlined the myriad downside scenarios on too many occasions to count.

Rather, I want to briefly highlight a possible bullish scenario for credit - as out of character as that might seem.

Recall that contrary to popular belief, I always explore both the bull and bear cases for any market I discuss. Just because I often come to the conclusion that the risk/reward scenario is asymmetrically skewed to the downside doesn't mean I didn't consider both sides of the argument. I just present the evidence and my analysis. It's up to you to decide how it fits with your own take on markets and what it means for your portfolio.

So one argument in favor of further spread compression simply amounts to the greater fool theory. When things overshoot (like say when HY spreads dip below 400bps), they tend to overshoot further. I discussed this on Monday.

There's also an argument for IG that revolves around spreads compressing as inflation expectations rise (see chart below).

(Chart: Citi)

Finally, there's the ubiquitous notion that central banks could always drive further tightening in credit spreads if they're willing to fall behind the proverbial curve.

Now to the point.

It's at least possible that the elimination of the deductibility of interest - for all the risks inherent in implementing such a change - could drive a further rally in credit.

How? Simple: supply. Or, more appropriately, a lack thereof.

Consider the following from Deutsche Bank (note: there's some really interesting points in the actual note about the knock-on effect for swap spreads, but I'm going to skip those here because frankly, I image most readers don't care - you're welcome):

An important aspect of the GOP's "better way" tax plan is the elimination of interest expense deductions. This could have a profound effect on corporate debt issuance. We estimate that in the worst case, removing interest expense deductions would lead to a drop in issuance of 28%.

The two charts below show the inverse relationship between bond yields and issuance volume. In 2016, gross new bond issues totaled $1.5 trillion, trailing just slightly 2015's total volume of $1.6 trillion, which was a record high since 2007. Between 2015 and 2016, the yield on corporate investment grade debt averaged 3.25 percent. The coefficient on this variable is negative, indicating as expected that high yields are a deterrent to issuance. It implies that a 1% rise in corporate bond yields would suppress issuance by about 31%.

What are the implications of the elimination of interest expense deductions for issuance? Interest expense deduction further the cost of debt to an issuer. At a 35 percent tax rate, a firm effectively pays just 3.25 percent on its 5 percent coupon debt. Hence, the removal of interest deductibility could be thought of as a onetime increase to a firm's cost of debt (ignoring minor accounting nuances such as interest capitalization). Without this deduction benefit, the same firm that was able to raise debt at 5 percent yield now sees a 54 percent increase to its cost of debt that is used in its WACC calculation. Our takeaway is that a substantial decline in corporate supply is likely to result from the impending corporate tax overhaul.

Got that?

That's kind of a sarcastic question. It really is pretty simple: remove the deductibility of interest and supply plummets.

Somewhat paradoxically (if you're thinking about it from a cost of debt perspective) this could actually end up driving further spread compression. Here's the Wall Street Journal to explain things in very simple terms:

If the Republican-led Congress has its way, the supply of new corporate bonds may soon dwindle.

Interest deductibility is controversial because it gives preferential treatment to debt financing over equity financing.

John Graham, an economist at Duke's Fuqua School of Business who has studied the tax advantage of debt financing, thinks the change would lead to "a notable reduction in the issuance of debt."

If some form of these plans makes it into law, it could set off a drought in corporate bonds. The result could be a rally in the market, a shift by investors to riskier assets and a chance for companies that still want to issue debt to do it at very low rates.

See why I say this is paradoxical? You've got the cost of debt going up thanks to the fact that corporations can no longer deduct their interest expense, but the cost of borrowing going down because of the resulting lack of supply (and assumed consistent demand).

In the end, there may be a case to be made for scarcity-driven spread compression. Or maybe not.

So there you go credit investors, a (sort of) bullish thesis from Heisenberg.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.