Capgains, the Dollar,
etc./Capital Gains Tax Relief Crashed the Junk Bond
Jude Wanniski and Alan Reynolds
September 26, 1989
CAPGAINS, THE DOLLAR, ETC.
The financial markets are understandably spooked by the recent developments m monetary and tax policy. The capital gains proposal that seemed on a fast track a few weeks ago now seems threatened by feverish Democratic partisanship. And the G-7 central bankers last weekend decided they wanted to drive the dollar down, with a heavy-handed statement that smells of currency devaluation rather than stabilization. Things are better than they seem, however. The Democrats seem sure to lose on the House floor on capgains, with 30 solid Democrats and another 50 leaning for capgains, only 47 needed in total if there are 5 GOP defections. A Gramm-Rudman sequestration seems unavoidable, at least for a few weeks, but that will lay to rest any doubt that President Bush can play rough. We still think the Senate will make the capgains cut permanent, with Chairman Lloyd Bentsen of Senate Finance appalled at the 2-year idea. As for the G-7 attempt to drive the dollar down, the Fed will simply sterilize, keeping gold from jumping, shaving fed funds carefully to steady the dollar. Yes, it looks stormy out there, but the good guys still have their bearings and control of the wheel.
CAPITAL GAINS TAX RELIEF CRASHED THE JUNK BOND MARKET
The mid-September crash of the junk bond market was widely attributed to a few actual and potential defaults; to new legislation requiring the S&Ls to unload their junk over five years, to fear that individual redemptions would force high-yield mutual funds to dump bonds to raise cash, and to fear that a recession will result in widespread defaults. These explanations seem inadequate. The idea that a few defaults would "collapse" the entire market requires the unlikely assumption that bond investors, unlike stock investors, can't tell the difference between extremely risky and less risky securities. Indeed, about 2.5% of junk bonds default every year, but that hasn't kept the market from doubling in size every two years. The S&Ls are not compelled to unload their junk bonds right away, and are not that big a player in this market. Mutual funds likewise hold only about 18% of the $200 billion in high-yield bonds outstanding (pension funds hold half, and individuals most of the rest). Recent redemptions among high-yield bond funds have only been in the tens of millions of dollars, not billions, and all the best funds hold enough cash so they don't have to dump bonds into a weak market. As for the idea that junk bond buyers are worried about imminent recession, that cannot explain why stock prices remained reasonably strong (aside from some takeover prospects) as the value of junk bonds was marked down. The fact that even the better junk bonds have been discounted suggests that there is more involved than default risk.
The missing element in the junk bond mystery is capital gains on higher-quality bonds (and stocks), and the increasing probability of a lower tax rate on those gains. The loss of corporate tax breaks in 1987-88 increased the incentive for companies to issue debt, while the increase in capital gains tax increased the incentive for individuals to buy high-income bonds. With tax rates just as high on capital gains as on interest income, securities previously held mainly for capital gains fell into disfavor compared with high-income instruments. Rather than catering to this new investor preference by paying higher dividends, firms naturally preferred to raise funds with tax-deductible debt. Interest expense would temporarily rise, until the junk bonds were retired, but corporate tax expense was reduced, with the net effect raising the value of leveraged firms. And the reduction of equity outstanding, due to buybacks and buyouts, meant smaller dividend payments forever, and higher retained earnings (which generate future capital gains to a reduced number of shareholders). 1
The relative allure to individual investors of seemingly certain interest income, rather than uncertain capital gains, was compounded by rising interest rates in early 1987 and late 1988. While AA and AAA corporate bonds provided only a 1.2% total return in 1987 (after subtracting capital losses from rising interest income), junk bonds paid 8.1%. In 1988, high-quality corporates paid 9.4%, but the overall return on junk bonds was 14.4%! 2 The superior return of junk bonds was reversed with the 1989 disinflation and consequent rise in prices of Treasury and high-quality corporate bonds. Through July, high-quality corporates provided a 11.4% rate of return, compared with 6.3% for junk bonds. Junk bonds barely participate in bond rallies, because holding periods tend to be short, and junk bond yields are dominated by cyclical or firm-specific risk, rather than by inflation risk.
The only reason for holding a high-quality long bond when the yield curve is flat or inverted is the hope of capital gains as interest rates fall. That motive has been reinforced lately by reduced inflation, but the incentive to invest for capital gains on high-quality bonds has also been enhanced by the probable failure of egalitarian Democrats to block a cut in the capital gains tax (or, as Ways and Means Chairman Dan Rostenkowski once suggested, to exclude bonds from the lower tax rate). In this situation, the relative attraction of high interest income on junk bonds is more than offset by the increasing attraction of capital gains on better-quality bonds (and stocks). Spreads between yields on junk bonds and Treasury bonds thus widen, from a normal 4% to something closer to 5%. The resulting capital loss on junk bonds is limited, however. The spread between junk bond yields and Treasuries rarely rose very much above 5% even with the LTV default and Boesky indictment in 1986, or the October 1987 stock market crash. This time, though, we expect a wide spread to persist, as capital gains again become relatively more attractive than interest income.
Assuming, as we do, that the capital gains tax will be reduced, the immediate effect has already been to reduce the demand for junk bonds, but the longer-term effect of relatively higher yields on junk bonds will also reduce the supply. This may well be bad for those takeover deals that rely on junk financing, though a lower capital gains tax is also good for any restructuring that involves new issues of stock. The reduced incentive to issue junk bonds should prevent further crashes in the prices of reasonably sound junk bonds (e.g., bonds of recent issue from noncyclical companies whose earnings suffice to make interest payments).
1 Diana Fortier, Chicago Fed Letter, January 1989.
2 Merrill Lynch index of 800 junk bonds & 1500 A A-AAA bonds.