WTW Warns of Potential Credit Portfolio Impacts Based on Tax Reform

Adjustments made to the corporate tax rate, repatriation of offshore cash and interest rate deductibility all are likely to have immediate effects on the credit markets—and by extension, on institutional investors’ fixed-income portfolios.

The latest Insights analysis published by Willis Towers Watson argues the 2017 tax reform law could have an enormous impact on pension fund credit portfolios, “one we believe has yet to receive the attention it deserves.”

According to Willis Towers Watson experts, while market participants have been focused on the benefits of tax reform for major risk assets, very few have taken into account the potential effects to their liability hedging portfolios. Among other likely outcomes, a reduction in top-line corporate taxes could decrease issuance of corporate credit, and in particular long-duration credit, described as “a key component to pension fund liability management.”

As the analysis spells out, the headline reduction of the corporate tax rate from a 35% maximum to a flat 21% has garnered much of the public’s attention since the passage of the Tax Cuts and Jobs Act in late 2017, “and rightfully so.”

“A lower tax rate affects the way companies manage their balance sheets as the relative attractiveness of financial engineering becomes less compelling and the value of issuing debt is reduced,” researchers suggest. “In addition, companies may no longer be incentivized to borrow over longer time horizons due to rising rates.”

Statistics in the report show how “issuance has tended to be inversely related to interest rates.”

“The combination of rising rates and a lower corporate tax could deter companies from issuing debt. While these dynamics may not take effect immediately, over the long term there is reason to believe that companies could deleverage as a result,” the analysis explains. “Similarly, repatriation offers companies the opportunity to bring cash traditionally held overseas back to the U.S. after paying a one-time tax rate. Companies that have assets tied up in other countries have typically been concentrated in select sectors, such as Technology and Pharmaceuticals, investing in short-term instruments, such as money market funds. Because they were unable to deploy the cash in the U.S., many turned to the foreign debt markets. It’s reasonable to anticipate that some portion of the funds eligible for repatriation will be brought back and made available to these companies. In doing so, the need for U.S. debt issuance is reduced.”

The analysis further argues that the reduction in allowance for interest rate deductibility could affect many lower-rated, high-yield companies.

“While not a part of the hedging portfolio, the high-yield market will help shape the new reality within credit as companies adjust their issuance patterns,” experts warn. “As such, it should be taken into consideration by investors as they review their portfolios holistically.”

Perhaps even more relevant for liability-focused investors such as pension funds or endowments are the findings regarding the U.S. corporate credit market and long-term debt. According to researchers, the U.S. corporate credit market “has witnessed tremendous growth following the global financial crisis of 2008, as companies have utilized historically low interest rates to issue long-term debt more cheaply.”

“As a result, long-dated corporate credit (securities with greater than 10 years to maturity at the time of data collection) has become a larger portion of the market as a whole, representing more than 30%, and has nearly tripled in size to more than $5 trillion as of December 31, 2017.,” the report explains. “While issuance is at an all-time high, spreads are near all-time tights, driven by investors’ search for yield. The U.S. primary issuance market has been one of the largest benefactors of this trend as U.S. yields have still looked attractive relative to their global developed market peers.”

The report suggests “nontraditional investors have contributed in a meaningful way to a significant supply/demand imbalance in U.S. credit as new issues have been heavily oversubscribed.” Related to these trends, the analysis argues “there is sufficient reason to believe that the shift in dynamics associated with the aforementioned aspects of the new tax law could lead to lower issuance over the medium to long term.”

“On the surface, much of what has been discussed points to a scenario that is favorable for long-duration credit markets as demand should continue to outpace supply, a positive for bondholders,” the report explains. “However, we believe investors must also consider the risk that capital will become more difficult to deploy due to scarcity, leaving pension funds in a troubling situation.”

As demonstrated in the report, total U.S. defined benefit liabilities outstrip the overall size of the Barclays Long Credit and Long Government/Credit indices.

“Despite the staggering growth of credit markets discussed earlier, it’s evident that supply in the market is already a concern—without incorporating other market participants that traffic in long-dated bonds,” the report states. “Though it is not our base case, a tail risk is that a significant amount of defined benefit assets could flow into the asset class during a time when supply weakens.”

With all this in mind, the Willis Towers Watson researchers present various “opportunities outside of traditional hedging assets other than long corporate credit that may be added to the hedging portfolio to help provide a diversifying source of long-term credit premia,” without major administrative burden. Explored in detail in the report, some of these include securitized credit, private credit and tax-exempt municipal bonds.

In conclusion, the experts say they believe that tax reform will be “transformational for credit markets,” and defined benefit pension plan sponsors need to ensure that they are prepared to confront the challenges that could arise.

“We have outlined a scenario in which corporate credit supply, particularly on the long end of the curve, could become strained during a time when these same assets could see rising demand. In this scenario, many plans may have unintended risks embedded in their hedging portfolios as a result of under-diversification that could lead to issues down the road,” the paper warns. “The part of their portfolio that is supposed to be sleepy could turn out to be anything but, and the consequences could be material.”

The full analysis is available for download here.