In the world of investments, the value of an asset should be correlated to the future returns that one can expect to receive from holding it for a period of time. The future return should incorporate future cash flows and repayment of the original principal.
The basic valuation of equity or fixed income securities is based on a set of cash flows discounted by a discount rate. As the expectation of the future cash flows change so does the present value.
Currently, the equity market has been adjusting its forecast of cash flows models to the upside. Greater fiscal spending by the government should have a direct impact on revenues. A reduced regulatory burden should lower expenses over time increasing earnings and cash flow. Lower corporate tax rates increase free cash flow for corporations to reinvest into the firm, payout to shareholders, or pay off debt.
Let’s look at how a tax cut, ceteris paribus, can affect both equity and corporate bond prices.
The U.S. corporate tax rate is 35% in the highest bracket. There is a plan in the House of Representatives that brings the tax rate to 20% and the current administration plan proposes a decrease to 15%.
The consensus view for 2017 earnings on the S&P 500 is $133. If the optimistic view of 15% is obtained, Ed Yardeni with Yardeni research, estimates that earnings on the S&P 500 could accelerate to $142, a 7.5% increase in earnings from taxes alone.
Much of the increase in equity valuations over the last few years has been from a variety of factors including: increasing dividends and stock buybacks through debt issuance, cost cutting to maintain high profit margins, and mergers and acquisitions. Leading into 2017 the market was debating if corporations could continue to increase earnings without revenues increasing. A tax cut should help put upward pressure on earnings.
When pricing corporate bonds a “credit risk premium” can be added to a risk-free rate, in this case U.S. Treasuries, to compensate the investor for the additional risk. One direct factor of the credit risk premium takes into account “capacity” to repay debt. Capacity is the ability to generate enough cash to repay obligations. When a company has less capacity to repay its debt the risk of default increases and the yield spread (calculated by the Treasury yield subtracted from the yield on the company’s debt), increases.
Currently, the credit risk premium is low. This is due to low interest rates along with supply and demand technicalities in the corporate bond market. Low interest rates have allowed companies to issue more debt to help pay dividends and stock buybacks as mentioned above. Non-financial companies have spent the cash, which has resulted in increasing leverage. JPM Morgan points to gross leverage levels of 3.2X which is well above historical average. The bond market has been debating on when the credit cycle will end, which could lead to an increase in defaults and credit risk premium.
However, if corporate tax cuts become a reality, ceteris paribus, the capacity to repay debt should increase and the current credit cycle should extend. This should create a tail wind to keep spreads tight.
All in all, investors have adapted investment models in the equity and bond markets. Recent valuation changes reflect the possibility of corporate tax rate reductions allowing for an increase to earnings and ultimately higher free cash flow for the corporation to use at their discretion.
Bill Lierman, CFA®
CIO, Fixed Income