Interest Rate Increases + Tax Reform = ?!? (Short High Leverage Ratios)

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Restructuring professionals have been waiting for interest rate increases for some time. Now that they're here, certain leveraged loan creditors are going to see an increase in interest expense. And just in time for a potential double whammy…

At the time of this writing, Congress has approved of the tax reform bill and President Trump is champing at the bit to sign it. Analyses are incomplete but one provision, in particular, is of note for restructuring professionals: the new limitations on deductibility of interest. Indeed, Fitch Ratings issued a press release confirming that the “impact of the deduction will be more severe on highly leveraged firms.” Choice quote: “Based on a sample of 575 leveraged loan and high-yield issuers, Fitch estimates that 37% of the issuers will lose a portion of their interest deductions under the EBITDA definition. In addition, 27% would be unable to deduct 20% or more of their interest and 10% would be unable to deduct 50% or more of their interest.” Get ready to see this in a First Day Declaration coming to a bankruptcy court near you.

Indeed, the prolific Baker McKenzie firm already has published its assessment. Choice quote, "These changes are significant to the struggling US corporation that has declining earnings.  Indeed, the path to bankruptcy for a highly-leveraged company could be accelerated as a result of an increase in its effective tax rate caused by these rules.  Moreover, the reduced allowance for deductions would mean fewer NOLs would be available for use should the company attempt a bankruptcy reorganization." There's also no grandfathering: you should read the piece. We're looking at you Tenet Healthcare (and others). Who knew tax could be so interesting?

That said, certain industries in need of relief could be potential winners. Retailers who generate profits domestically stand to benefit from the corporate tax rate reduction. On average, they pay 30.6% currently so a reduction to 21% could be meaningful. Likewise, restaurants with domestic profits would also stand to benefit (multi-nationals with a higher mix of U.S. debt to earnings could run into the deductibility issue above). These two spaces could use all the help they can get after a bumpy 2017.

Finally, tax lawyers and tax advisors are already getting busy poking holes through the thing.