Things to think about in corporate debt - Tax changes beyond the rate

Analysts have done a good job of accounting for the Trump corporate tax changes that went into affect in 2018, but there are some potential time bombs that will affect the riskiness of corporate debt. Corporate tax rates have fallen to 21% but there is now a cap of 30% on the deduction that firms can take from EBITDA and 30% of EBIT in 2022. The cost of capital for highly levered firms under this environment will be higher. Highly levered firms are penalized versus the firm that has limited debt. The interest deduction cap may create situations where levered firms will pay more in taxes and this will spillover to the spreads for lower rated firms. 

Given this change, the use of EBITDA may be replaced with EBIT as a better measure of firm cash flows.  From SP Global Intelligence, we can compare different ratings with interest expense to EBITDA or EBIT. First, the ratios monotonically increase with a decline in ratings. Second, the interest expense versus EBIT will be higher. Third, the interest expensive coverage can see large changes based on changes in earnings. Look at the variation over periods of less than a year. Earnings variation will impact coverage ratios which will lead to more spread variation.

While the change in tax law may not have a dramatic affect in a stable earnings environment, capital costs and risk exposures do change when the structure of taxes are altered. Just following tax rate changes is not enough. This tax decrease will not be welcomed by those that have strong borrowing needs.