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After a significant bond market sell-off at the end of 2016, the first quarter has seen prices (and interest rates) settle into a more stable range, even with two increases to the federal funds overnight lending rate over the quarter. On February 1 and March 15, the FOMC (Federal Open Market Committee) increased the benchmark rate by 0.25% at each meeting. The target range for the rate now stands at 0.75%-1.00%. These changes have had more of an effect on variable rate mortgages and loans that reprice based on short-term rates or the prime lending rate. Most banks establish prime rates at a spread of 3% over the fed funds rate. So, currently most prime rates stand at 4%.


We can see from the following chart that there has been slight change in interest rates since the end of last year. This may surprise some of you. But despite the Federal Reserve Bank’s change in monetary policy to a tightening bias, the bond market is not expecting interest rates to go much higher. Of course, that is the sentiment at the moment. We would expect this to change depending on how global economies, including our own, react to policy and regulatory changes that could impact growth, inflation, and taxes. 



When managing investment assets one needs to be aware of the potential risks that are associated with the expected rewards. Managing risk is a fundamental part of our job. With fixed income investments, the risks that historically have impacted asset values are interest rates, credit or risk of default, and optionality or pre-payment risk. While no one can precisely eliminate all risk without eliminating all reward, these risks can be managed through portfolio diversification. It is becoming more apparent that there is another risk that is playing a bigger role than previously experienced in asset allocation and investment management: political risk.


As the role of government has evolved to encompass more of our everyday life, the policies, rules, and legislation that have been put in place do have an impact on economic activity. Finding a balance between government policies and free market capitalism that promotes economic growth and wellbeing has become more difficult. This has become increasingly evident over the last 20 years as politics have become more partisan and narrower in scope. It is not surprising, then, that capital markets pay more attention to the political environment in Washington, D.C. The renewed post-election optimism we discussed last quarter may be at risk unless some of the expected pro-growth policies are implemented. The discordance in Washington between political parties in Congress and the current White House administration gives us pause to evaluate whether finding consensus on anything is truly possible. 


The equity markets are still pricing in the expectation for a positive outcome with respect to reducing regulatory hurdles and tax reform. The bond market has yet to affirm that expectation. The inability of Congress to effect changes (or even gain consensus on those changes) to the Affordable Care Act puts other expected policy implementation at risk. This might explain why interest rates have stabilized and are not projecting the same expected economic outcome and why the equity markets had their first negative performance month in March. 


It appears that the next major policy initiative will focus on corporate and individual tax rates. It is still highly uncertain how these policy changes will be structured. There seems to be some agreement across political parties that the corporate tax rate could be lowered to make U.S. companies more competitive globally and create incentives for further capital investment and growth. The current top marginal federal tax rate is 35%. This rate does not include state and local taxes which only add to the corporate tax liability. The task of gaining consensus on tax policy that would be agreeable to both political parties and signing legislation is going to be difficult. Negotiating a “fair” tax policy is still going to be subjective because of various interest groups that could be affected disproportionately. There are many variables that could affect the ultimate tax law. However, at the core of the debate is how to lower taxes without increasing the deficit, commonly referred to as “revenue neutrality.” Two potential ideas that are being discussed as a means to achieve revenue neutrality are the Border Adjustment Tax and the elimination of interest expense deductibility. We want to emphasize again that any kind of analysis regarding the possible path for tax reform is speculative at this point, but we’ll explain the ideas being presented and their potential economic impacts.


The Border Adjustment Tax is designed to only tax the sales or revenues generated domestically, while levying no tax on exports or sales generated abroad. As one would imagine, this would be extremely unpopular with companies that are large importers of goods. While this could create an incentive for companies to produce in the U.S., it also shifts costs on those consumers of imported goods. Perhaps less concerned are U.S. small businesses which import very little. It is also estimated that this tax will help “pay for” the reduced marginal tax rate by raising close to $1 trillion in revenues. 


Eliminating the interest expense deductibility would not affect all corporations in the same way. Certainly, corporations that historically have used more debt financing would be impacted more negatively.  Highly leveraged industries, such as banking, would have increased after-tax liabilities and lower profit margins. How would banks address this? The most likely answer would be to increase revenues on loans and services through passing these higher costs onto the consumer. 


The elimination of the deduction here in the U.S. could also create incentives for corporations to borrow overseas where the deductibility would still exist. There could be a shift to places where the after-tax cost of borrowing is lower, in turn allowing corporations to redeem higher after-tax borrowing here. This is not a riskless strategy as exchange rates would also play a role in determining whether it is cheaper to borrow domestically or abroad. Nonetheless, this “adjustment” would most likely reduce the supply of corporate bond issuance marginally. The impact would likely be even lower bond yields as the supply dwindles in the face of consistent demand for fixed income cash flows. Bond prices rise and bond yields fall. It is estimated that eliminating this deduction could produce more than $1 trillion of U.S. tax over the next decade according to the Tax Foundation.1 


As for individual tax policy changes, as we mentioned last quarter, we believe that tax reform now will be less effective than when President Reagan successfully negotiated and signed the Tax Reform Act of 1986. The primary reason is that the 1986 law reduced marginal rates from 50% to 28%. The current top marginal personal rate is 39.6%. In order to get a decrease of the same magnitude, the top rate would have to decline to approximately 22%. It’s hard to imagine that would be approved. With fewer people in the workforce and the aging of our society, there will be more of a cost burden on entitlement programs such as Social Security and Medicare.  These rising costs will be difficult to offset with fewer people working, let alone lower taxes. These costs must be financed either through taxes or borrowed money. Adding more to the national debt through debt financing just to cover the cost of entitlements is more of the same policies that really add nothing to economic productivity or growth. Addressing only taxes (government revenues) without also addressing how the government spends these revenues is not a sustainable nor healthy policy for promoting good economic health. Remember that capital is not infinite and does manage to find its way to its most efficient use. 



1 www.bloomberg.com/news/articles/2016-12-16/republican-tax-reform-seen-shrinking-u-s-corporate-bond-market

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