by Thomas O'Reilly, Head of Non-Investment Grade Credit, Neuberger Berman
Fixed income investors have had a pretty good run over the last year. The election of Donald Trump as the 45th president of the United States was a non-consensus outcome and has already had an impact on markets. The latest proposals being discussed on tax and trade could shake things up a little more.
In my own field, non-investment grade credit, the fundamentals remain sound. Default rates are low, and we believe they are likely to decline further during 2017 to around the 2% level. Earnings are generally stable, with a high degree of exposure to the modestly growing U.S. economy at approximately 80% of revenues, and new money has been flowing into the asset class.
So what’s the downside?
One of the answers is policy uncertainty. A potential source of volatility may be the new administration’s policies on tax- and trade-related issues. Tax changes under consideration are the largest in several decades. Trade policies being discussed appear to be more protectionist, creating risks to those companies that source the bulk of their cost of goods from outside of the United States.
Impactful…but Not Systemic
First, let’s look at taxes. There’s a raft of proposals under consideration, including cuts to individual and corporate tax rates, a move to a territorial tax system and encouraging repatriation of foreign cash. Within non-investment grade credit, one of the most topical issues is the deductibility of interest expense. Some of the proposals being discussed include the removal of interest expense as a tax deduction but would permit the full expensing of capital expenditures. The balance between interest expense and capital spending will become key in this environment. Based on our analysis, the elimination of interest deductibility would only have a negative impact on 10 – 15% of the U.S. high yield market. That’s because most issuers maintain a balance between interest expense and capital expenditures, with several large high yield index constituents, such as Energy, Telecom, Utilities and Hospitals, maintaining capital spending that is greater than interest.
There’s likely to be a number of permutations in this new legislation as we progress through the year. It could also take some time to become law, if the efforts are successful at all. But we believe that it is important to focus on these issues now, while credit spreads are not differentiating between issuers with elevated risk to policy change and those with limited exposure.
Trade and Border Adjustments
Moving on to trade, in our view the key point is cost structure: What percentage of inputs is imported into the U.S.? Most industries in our market are appropriately matched, sourcing their cost inputs in the same jurisdictions where the products are sold. We believe only 10 – 15% of the market would be negatively impacted by changes in trade-related policy, including tariffs or border-adjusted taxation. The retail sector is the primary example. It sources 50% or more of its materials from outside the U.S., often from Asia, and then sells these goods into the domestic market. The implementation of a border tax or tariffs, therefore, could have significant downside implications for retail issuers. The more domestically focused sectors in the market, including Cable, Telecom, Utilities and Energy, will likely remain largely unaffected by these issues. So, again, we’re not talking about systemic risk to the market.
In Europe, meanwhile, much of the focus is on “Brexit” and the forthcoming elections in France, Germany and the Netherlands. The European high yield market is not completely immune to some of the proposed changes taking place in the U.S., but we anticipate that the primary focus will be on economic and political trends within Europe.
From an investment perspective, we think a key differentiator in performance will be mitigating downside risk related to policy changes. Investors will need to be forward looking and position themselves carefully in order to avoid potential negative surprises. You can read more in the recent Neuberger Berman Fixed Income Investment Outlook.
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