Junk bonds - tax reform and valuation

 Chas Craig, BridgeTower Media Newswires

Per a January 2018 Deutsche Bank presentation citing data from JPMorgan and S&P Capital IQ, while the new tax code is beneficial for the cash flows of about 75 percent of high-yield (HY) issuers (i.e., junk bonds), within the CCC and lower subsector (i.e., distressed debt), this result is flipped, with 75 percent of this more aggressively financed cohort taking a hit to cash flow due principally to the new limitations placed on interest deductibility (deduction limited to 30 percent of EBITDA for tax years before 1/1/22, 30 percent of EBIT thereafter). This challenge may not be well-appreciated by the market at present, as distressed debt has continued its recent outperformance relative to the overall HY market (10.6 percent vs. 7.5 percent in 2017), returning 2.7 percent YTD compared to the overall HY return of -0.3 percent (return figures courtesy of ICE BofAML).

If distressed debt defaults pick up or if yield spreads to comparable maturity U.S. Treasurys widen out for more leveraged paper in general due to fears of lower interest coverage brought on by lower cash flows, the market declines could reach the entire HY space. An analogous event occurred in early-2016 when the warranted (at least directionally, though probably not in magnitude) sell-off in HY energy credit (energy comprises 10 to 15 percent of the overall HY space) infected the entire HY space, sending credit spreads to recession-type levels despite non-energy HY defaults remaining near zero.

Also, beyond issuing bonds to the HY market, many junk bond issuers also employ a great deal of bank debt, which typically fluctuates with short-term interest rates. One such benchmark is three-month LIBOR, which has increased by more than a full percentage point over the last year. Theoretically, this increased debt service burden should already be accounted for in asset prices, but since the higher levels of interest have likely not yet fully flowed through to reported financials and given historically tight credit spreads (for both the overall HY market and the distressed subsector), I question if this phenomenon has investors’ full attention just yet. Relatedly, higher interest rates in general will make it costlier to refinance existing HY debt when it comes due, which it does frequently given the relatively low duration of the space (4.2 for all HY and 3.3 for CCC and lower) compared to the overall U.S. bond market (5.9).

Below is a mid-2007 quote from J. Ezra Merkin in his introduction to Part III (Senior Securities with Speculative Features) of the Sixth Edition of Benjamin Graham’s and David L. Dodd’s Security Analysis, the first edition of which was published in 1934 and is widely recognized as the “Bible of Value Investing.”

“Of course, it is very difficult to predict where the spread will move tomorrow or next week, but opportunistic investors recognize diversions from the norm. When the spread is particularly wide, they go fishing; when it is particularly narrow, they stay close to home and mend their nets.”


Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).