Profit repatriation and the bond market
With an election fast approaching, we have been thinking about how the outcome of the presidential election could affect capital markets. One aspect that we feel has not gotten enough attention is how it could impact the investment-grade (IG) corporate bond market. One of the topics that was “in play” before gun-control, minimum wage and immigration stole the spotlight was tax reform and the possibility of a “repatriation tax holiday,” or a short window of time in which US corporations could transfer profits held by offshore subsidiaries to domestic holding companies and pay a federal corporate income tax lower than the current statutory 35% (IRS Pub 542), which most republican candidates have expressed support for. As reported by CNBC, Citizens for Tax Justice estimates that US companies have about $2,100 billion in profits held by offshore subsidiaries which have not yet been taxed in the US. That translates to roughly $735 billion in deferred tax liabilities at the 35% statutory rate.
As you can see in the infographic above sourced from the linked CNBC story, some of the companies that accumulated the largest amount of offshore profits are familiar names, many of which regulary issue debt in US markets. Why would a company that has billions in liquidity in excess of what it needs to operate its business issue more debt? Because they can’t access that liquidity without having to pay the corporate income tax. Instead of repatriating profits to reinvest into their business or return to shareholders as buy-backs or dividends, these companies issue new debt in the US to fund those activities while investing the assets of their offshore subsidiaries. In fact, some of these offshore profits have accumulated to such highlevels that the companies have set-up new companies to manage the assets by investing the profits in treasuries, MBS, or high-grade corporate bonds, much like regular bond funds. The most famous of these is Braeburn Capital which is rumored to manage over $200 billion for Apple.
Due to the large sums of financial assets, a repatriation holiday or tax reform that encourages some repatriation could affect financial markets in the following ways:
- Composition of debt market: As these large issuers are able to access their offshore liquidity they would no longer need to issue debt. They could also sell existing holdings. This would likely lead to bond funds, particularly bond index funds, becoming less diversified.
- Sudden technical pressure: In the event of coincident repatriation by many actors, large tax bills would be due. The repatriating companies would have the option of selling some of the investments held by these subsidiaries in order to meet the tax liability or issue new debt. In both cases it would create a sudden and temporary surge in supply. Likewise, these companies would be unlikely to make additional investments with new profits or proceeds from maturities, temporarily reducing demand.
- Equity Leverage Ratios: For many of these companies, the accumulated profits are likely to be well in excess of the liquidity necessary or desirable to run the day-to-day operations of the business, and a return of capital to shareholders would be of high probability. Given the evidence of tax-sensitivity by managements, the likelihood is high that this return of capital would happen primarily through tax-efficient buy-backs instead of special dividends. This would effectively lower the assets backing the existing debt of the companies which could lead to potential credit downgrades by ratings agencies. Note that there would be little to no consequences from these downgrades to the companies in question as they likely generate sufficient free cashflow to not necesitate external funding. If you are not planning to — and are highly unlikely to need to — issue debt, your credit rating carries little significance to operations. Additionally, the cash returned to shareholders would likely need to be invested *somewhere*. Risk preferences would suggest that the shareholders selling into a hypothetical buyback or receiving hypothetical special dividends are unlikely to be the marginal demand for the hypothetical fixed-income assets sold by the repatriating company to perform such an action. This could create a momentary technical imbalance which cheapens some bonds relative to stocks. Given the large weights of many of these companies in stock-indices, it would also affect index statistics such as book-value resulting in higher price-to-book ratios coupled with higher return-on-equity ratios. It would also create a wealth of potential taxable events like dividends recieved and potential capital gains for stockholders that sell into any potential buybacks, boosting federal and state receipts.
- Treasury issuance: Even a partial repatriation, or simply a decrease in future profits retained in foreign subsidiaries, would likely generate non-trivial amounts of revenue for the federal government and some states. In the case of a highly-utilized tax-holiday it could create a substantial windfall which would, absent one-time spending, reduce the issuance of treasuries, at least momentarily.
- Investment Management Industry: Large parts of the investment management industry earn money by charging a recurring fee to their clients, most often calculated as a percentage of the assets they manage. The current state of offshore profits can be thought of as a chain of liabilities. Offshore subsidiaries hold X in offshore investments, domestic parents borrow Y backed by the ownership of offshore subsidiaries to access liquidity, and the resulting deferral of tax liabilities cause the Treasury to emit more debt than if it had higher receipts. Any significant repatriation of assets would lead to a “netting” event in which the liabilities are settled and the overall gross stock of debt is reduced even if the net level of indebtedness remains the same. Combined with any signifcant return of capital to shareholders triggering more taxable events this would be, all-in, an event that reduces the gross amount of financial assets in the system. And the investment management industry as a whole has revenues that are a function of the sum of the gross value of financial assets, of which corporate liabilities, corporate equities, and government debt, are all a part of.
Because of the many uncertainties involved in the chain, this whole essay is highly speculative; however, we at New River Investments Inc. enjoy speculating about just these types of events to create mental models of how they could affect capital markets or the economy as a whole.
Author’s note: I think a tax repatriation holiday is possibly one of the worst mistakes our government could make. As a business-owner (in California, no less!) I am painfully aware of how harsh corporate income taxes can be, but the solution is not a one-off repatriation holiday. A repatriation holiday incentivizes company managements to hold-out until such an event to experience the lowest possible tax rate and creates an unfair and unbalanced playing field that benefits large corporations able to play these tax games by awarding them lower effective tax rates. It’s basically a giant give-away to billionaires. It also creates lumps in tax revenue which can be abused by congress. We’ve spent 4 years under a legislature intent on reducing spending at a time when yields were at record lows and the economy needed the fiscal stimulus. It is my opinion that they are now planning on using such a tax-holiday to access a “windfall” in revenue if the presidency is held by a Republican government, in effect starving the budget until one side has bigger control of it. That revenue would not be a windfall, it would be an asset that had been accrued for many many years and which should not be used as way to justify any sort of one-time events or changes in fiscal policy. A wiser approach would be to lower the corporate tax rate so as to reduce the advantages of leaving those profits offshore and reduce the inefficiencies associated with it, like, for example, issuing debt locally while there is cash abroad to delay the tax liability; likewise, I can’t imagine the accountants, consultants, lawyers, and asset management teams required to keep playing this game are cheap. I rarely enjoy seeing anyone lose their job, but I suspect they will land on their feet. — Guillermo Roditi Dominguez