The Tax Cuts and Jobs Act will affect many aspects of the investment landscape, and a few key elements could help bolster more higher quality speculative-grade debt securities and bond-related ETFs.
The newly implemented tax reforms will lower the U.S. corporate tax rate to 21% from 35%, set the amount of interest expense that companies can deduct to 30% of EBITDA and allow companies to fully write off capital expenditures in the year spent for at least the next five years.
“We view these changes as a net positive for the high yield bond market,” and “the new tax plan could impact BB and B rated issuers differently than more highly levered CCC rated issuers,” Eric Legunn, ETF Strategist for Deutsche Asset Management, said in a research note.
The ETF Strategists found that only about 10% of debt securities held by the Xtrackers USD High Yield Corporate Bond ETF (HYLB) may be negatively affected by the new tax regime due to the drop in headline tax rates to 21% and capped interest rate deductibility of 30% of EBITDA, so the majority of HYLB’s portfolio would experience a net positive.
Furthermore, Legunn argued that more highly leveraged or junkier debt securities could be negatively impacted by the tax reform changes while more highly rated speculative-grade securities could outperform.
“Highly-levered CCC companies could experience a larger wave of defaults than previously expected prior to the new tax plan,” Legunn said. “In contrast, less-levered BB and B rated issuers may experience upgrades as they could become more profitable under the new plan. Relatedly, if one were to divide the high yield market into two segments, one comprised of higher-rated higher-quality bonds and another comprised of lower-rated lower-quality bonds, the higher-rated segment of the market might perform better than the lower-rated segment of the market under the new tax regime.”
Consequently, investors who want to capitalize on the potentially rosier outlook of the higher rated junk debt segment can consider something like the Xtrackers Low Beta High Yield Bond ETF (NYSEArca: HYDW). HYDW tries to reflect the performance of the Solactive USD High Yield Corporates Total Market Low Beta Index, which includes junk-rated debt that exhibits lower overall beta to the broader high-yield bond market. Consequently, the portfolio is comprised of lower-yielding junk bonds with higher-credit quality that show a lower beta. HYDW shows a 4.22 year modified duration and a 4.05% yield to worst.
For more information on the fixed-income space, visit our bond ETFs category.