The specific proposal introduced by Senate Finance Committee Chairman Max Baucus (D, Montana) calls for deferrals of taxes on gains from debt repurchases at discounted levels. Any income realized from debt buybacks in 2009 and 2010 will be deferred to 2011 and then taxed ratably over an eight year period, through 2018. Let's demonstrate: if an issuer buys $1 billion of its debt at 50 cents on the dollar, the result is a $500 million capital gain and $100 million tax bill at a 20% statutory rate. With the current proposal, assuming a two-year deferral and pro-rata payment over 8 years, the present value of the tax payments becomes $54 million - a $44 million pick up in value! The difference is substantial and could potentially be distributed pro-rata to the company and its bondholders, implying the repurchase price could be increased by 5-6 cents. This could lead to a whole new form of company-bondholder negotiations, especially for large companies whose debt is trading at a large discount.
As a large portion of debt trades at distressed levels, with 70% of the HY market and 12% of investment grade trading at distressed spreads over 1000 basis points, this proposal would create large incentives for companies to consider buying bonds in the open market.
Even prior to this proposal, with its embedded benefits, companies had been aggressively buying back debt over the past 2 months (table below). As we discussed in the linked article, the benefits to a company from open market repurchases are numerous. It is likely that the stimulus bill will incite even more companies to buyback their own distressed debt, and asset managers to piggyback on this trend by pre-purchasing the bonds of companies they believe are most likely be bought up in open market repurchases. However, investors will have to be very careful not to misprice the overall high yield market higher, which as we wrote yesterday, could potentially be rich to the tune of 14 points based on a set of expected default and recovery rates.
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