The proposed Republican tax plan may not be as big a boon for the economy as suggested by the performance of U.S. stocks.
While equities have soared the past month on the rising prospect for corporate tax cuts, corporate bonds have done little. In fact, a basket of bonds from major companies with high tax brackets has even shown negative returns.
Bond investor skepticism contrasts with the general notion among economists that lower taxes can be quite advantageous to companies with large amounts of leverage in their capital structure as measured by combined debt and equity financing. Interest paid on debt is tax deductible, and issuing bonds effectively reduces a company's tax liability. So, by lowering the corporate tax rate, bondholders of companies that pay high tax rates should benefit — or so the thinking goes.
In many ways, the performance of corporate bonds is more in line with recent moves in the market for U.S. Treasuries. There, the so-called yield curve that measures the difference between short-and long-term bond rates has been narrowing. Much of the narrowing has come from a rise in short-term yields, which have increased by more than 50 basis points for the two-year note since early September. As a result, yields on shorter maturity corporate bonds have risen as well, with borrowing costs on debt due anywhere from six months to two years jumping more than 75 basis points.
A flatter credit curve is generally associated with an expected slowdown in earnings growth and an increasing risk of defaults.
The rise in short-term corporate borrowing rates boosts the cost to roll over maturing debt (more than $800 billion comes due in 2018) at a time when leverage is already high. It's not hard to see the corporate credit curve moving closer to inverting as the Treasury curve flattens, pushing short term company bond yields to 2.5% to 3%.
Here are three reasons for concern.
1. Treasury and Corporate Yield Curves
