At the outset of the year, corporates are contingency planning for the potential impact of the Republicans gaining control of both the legislative and executive branches of government. Policy shifts and legislative changes to healthcare, energy, trade and taxation are the primary areas of focus. Since it is pure speculation how the legislative process will unfold on these matters, our sense is the majority of Corporate America is concentrating time and resources on the implications of tax reform. The transition rules from the current system to the new tax system will be critical as it can create opportunities and pitfalls and Mizuho is endeavoring to help our clients navigate what will undoubtedly be a complex path.
The key features of tax reform impacting financing and overall capital structure decision making by corporates is the overall tax rate, ability to efficiently repatriate cash from overseas operations and the potential change in deductibility of interest expense of debt. Mizuho’s dialogue and advisory work with corporates regarding tax reform has been concentrated in five key areas: liability management, interest rate policy for fixed/floating mix, repatriation of overseas cash, pre-funding analysis of future capital obligations and the role of hybrid and equity capital in the overall capital structure. Below is a brief overview of the considerations Corporate America is having on each of these topics as it relates to potential tax reform.
- Liability management: corporates have been particularly proactive in managing their liabilities through early redemptions (tender and/or exchange offers for existing bond obligations of the company) in order to lower their interest expense and/or to extend or smooth the maturity profile of their liabilities. The expected reduction in the corporate tax rate suggests tenders for high coupon bonds should be executed sooner rather than later to realize the prevailing 35% tax deduction and improve the net present value savings of redeeming an outstanding debt obligation prior to its maturity date. On a go-forward basis, the reduction in the corporate tax rate would increase the interest expense savings associated with refinancing high coupon debt.
- Interest rate policy for fixed/floating mix: many corporates are overly fixed in terms of the form of interest expense they pay on their liabilities and have been waiting for higher prevailing interest rates to enter into derivatives transactions whereby they can swap these fixed interest expense obligations and essentially convert to paying interest expense as a function of a spread to LIBOR (i.e. a floating rate). The rise in underlying interest rates has made the post-election time period a more economic time to consider these transactions. In addition, a reduction of the corporate tax rate would increase the initial interest expense savings of swapping fixed obligations to floating.
- Repatriation of overseas cash: a change in the tax code allowing for international subsidiaries to repatriate dividends with a 100% exemption, in addition to a one-time tax holiday for overseas cash, will likely reduce domestic funding needs. However, if the tax holiday also allows for multinationals to repatriate historical earnings that have already been reinvested in the business, debt issuances may be necessary to bridge the gap with on-hand cash.
- Prefunding analysis of future capital obligations: corporates are reassessing their current interest rate outlook and are considering accelerating funding needs to get ahead of a higher-rate environment as the “cost of carry” for six months is well within treasury yield projections. Issuers with upcoming funding needs are taking a more proactive approach during opportunistic windows, given the greater “tail risk” associated with how the legislative process might unfold.
- Hybrid and equity capital: certain lawmakers have called for an elimination of the tax deductibility of interest expense; either the full elimination or an overall reduction of the corporate tax rate will increase the after-tax cost of debt. While debt will still be the cheapest form of capital for most investment grade corporates, this will make hybrid and equity capital more attractive on a relative basis. Relatedly, there has been some speculation that existing debt issuance may be grandfathered in terms of deductibility which could play back into the question of prefunding.
Despite the uncertainty and broad implications of legislative changes, corporate behavior towards debt issuance has not wavered. In fact, there was north of $50 billion of investment grade corporate bond issuance in the first week of 2017, and across the board these debt offerings were met with strong investor demand resulting in favorable execution terms for most of the issuers. Of this $50+ billion of issuance, Mizuho served as an active bookrunner on $10 billion of this volume by acting as an underwriter for four corporate issuers.
Serving as a bookrunner on these offerings provides us with real time insight into investor preferences and overall outlook for risk assets such as corporate bonds. First, it is abundantly clear that there remains significant amount of investor cash dedicated to and focused on buying credit products. As a result, we continue to see strong demand for longer duration which translates into even flatter credit curves and lower costs to extend maturities for issuers. Second, investor demand for floating rate notes increased with the start of 2017, which is a telling sign of how they are judging the potential future path of interest rates. Finally, investor preferences for lower rated and more volatile credits (e.g. higher-beta) was prominent as the execution for these issuers outperformed the tighter trading and higher rated issuers.
Mizuho prides itself on providing sound strategic advice on capital structure planning such as the implications of tax reform. Meanwhile, we are also working hard to deliver world class execution on debt underwritings for our corporate clients by leveraging our differentiated insight and relationships with investing clients.
This document is NOT a research report under the legal requirements in any country or jurisdiction designed to promote the independence of investment research and is NOT a product of a fixed income research department. This document has been prepared for institutional clients, sophisticated investors and market professionals only, on the basis of publicly available information. This communication has been produced by and for the primary benefit of a syndicate desk. It is not investment research nor considered impartial in relation to the activities of this syndicate desk.