The reduction in corporate income tax rates is expected to increase tax exempt yields for hospitals, and could reshape the market for bank direct placements and public bond offerings, particularly for lower rated borrowers.
With the lowering of the corporate tax rate from 35% to 21%, munis will be less attractive to corporate buyers relative to taxable yields, and this could have a material impact on the interest rates paid by not for profit hospitals and other muni borrowers in bank direct placements and in the public bond markets.
Bank placements could be affected the most, because banks pay more taxes than other corporate buyers.
The magnitude of the impact will depend on the bank’s effective tax rate, which tends to vary based on tax breaks and deductions. According to data compiled by Aswath Damodaran at the NYU Stern School of Business, last year regional banks paid an average effective tax rate of 25%, and money center banks paid an average of 28%.
For a bank with a 28% income tax rate, a 4% tax-exempt rate is equivalent to an after-tax rate of 4% / (1-0.28) = 5.55%. This is known as the taxable equivalent rate. If the bank’s income tax rate is lowered to 21%, the taxable equivalent yield drops to 4%/(1-0.21) = 5.06%, making the tax exempt yield less attractive relative to receiving a taxable yield. To return to the previous taxable equivalent yield of 5.55%, the tax exempt yield would need to be increased to 5.55% x (1-0.21) = 4.38%, a 38 basis point penalty to the borrower compared to the original 4% yield.
While the tax exempt interest earned as profit remains the same, it is less valuable relative to taxable yields, so some lenders may ask for higher tax exempt yields.
Other lenders may reallocate their balance sheet away from tax-exempt debt and into taxable loans, which will affect supply and demand, potentially leading to higher tax exempt yields.
The higher the rate paid by the borrower, the greater the impact of the change in corporate income tax rates on the relative value of taxable vs tax exempt interest to lenders, so lower-rated hospitals who generally pay higher rates will be more affected.
Yield maintenance language in bank placement documents may not be much of an issue because it is designed to maintain the bank’s after tax profitability if a change in tax or regulatory regime decreases after tax profits, which is not the case here unless the formula is based on a taxable equivalent calculation.
In the public bond markets, the impact of corporate tax reform could be less noticeable for a couple of reasons.
First, the majority of buyers are households (direct retail) and mutual funds (back door retail). Most direct and back door retail will not be affected by changes in corporate tax rates.
Second, insurance companies (who represent a portion of non-retail buyers) pay an average effective tax rate of 18% to 23%, so they are less affected by tax reform than banks.
It will be interesting to see exactly how yields adjust to tax reform in both the private and public bond markets.