The recent defeat of US President Donald Trump’s repeal of the Affordable Care Act has cast doubt on his tax reform proposals, and bond investors should look to “take risk off the table”, according to FIIG Securities.
FIIG head of credit strategy and research Mark Bayley cautioned that the defeat of Mr Trump’s proposed health care reforms posed “big questions about his ability to enact any of his election promises” and this could have an impact on company profitability, the supply of high-yield bonds and how the tax system will change.
“Given where we are in terms of the credit cycle (mature bull) and current level of high-yield credit spreads (tight), the uncertainty around Trump’s tax plan seems like another reason for investors to take some risk off the table while waiting to see how it pans out,” he said.
“I believe that in the financial markets the risk versus return equation is very asymmetric; there are big risks to the downside and not much additional return to the upside. This potential tax change adds to those risks, especially in US high-yield.”
Mr Bayley said that if the tax reforms were approved by Congress, equity would become a more attractive form of capital than debt, which could prompt businesses to issue more equity.
“For bondholders, that has the potential to be positive on two fronts. Firstly, a company’s credit quality would be improved by having more equity in the capital stack,” he said.
“Secondly, there would likely be fewer bonds issued, thus creating a positive technical impact as investors scramble for a dwindling pool of corporate bonds.”
Bondholders may also be able to redeem their bonds at par if the reforms pass “due to optional redemption clauses surrounding the elimination of tax deductibility of interest”, however data from CreditSights found “only a handful” of large bond issuers explicitly tie in interest deductibility to a par call optional redemption.
“While there are still many unknowns and uncertainty, if Trump’s corporate tax plan does succeed and passes into law, then the impact on US high-yield companies and their bonds is likely to be negative,” Mr Bayley said.
“As such, given the strong recent performance of high-yield bonds and the current position in the credit cycle, it can be argued that now is a sensible time to take some profits and risk off the table.”
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