Editors' pick: Originally published March 2.
Much remains up in the air in terms of what will get done -- and when -- on President Trump's tax-reform plan. Overall, my sources believe that what ultimately becomes law will be smaller than discussed and take longer to implement. Having said that, it's wise to prepare for possible changes so that you can manager your portfolio effectively.
Let's check out how to income investors should play what's likely to happen:
Tax Cuts for Individuals
I expect cuts to individual tax rates to become law in some way, shape or form, which will have the most immediate impact on municipal-bond funds and dividend-paying stocks. These investments' favorable tax treatment will see some impact. However, as you can see from this chart of the iShares S&P National AMT-Free Municipal Bond Fund(MUB) - Get Report vs. the iShares iBoxx U.S. Dollar Investment Grade Corporate Bond ETF (LQD) - Get Report , municipal-bond spreads have already widened in anticipation:
I think investors should be on the lookout for overreaction in the municipal-bond space, particularly buying opportunities among closed-end funds. If municipal bonds sell off too much relative to any actual changes in tax laws and discounts to NAV increase, look to add to municipal-bond exposure despite any cut to federal tax rates.
Repatriation, Interest Deductibility and Accelerated Depreciation
In the corporate-tax space, I believe proposed reforms to cash repatriation, interest deductibility and business depreciation will come as a package, and I predict that:
- U.S. corporations will see favorable tax treatment on any repatriation of overseas cash. This will positively impact Big Tech the most.
- The U.S. Tax Code will limit deductibility on business interest expenses, although I'm hearing discussions on various ways to grandfather current rules this. Still, this will ultimately impact highly leveraged companies with low growth potential the most. However, there's also talk of accelerating business depreciation, which will benefit capital-intensive businesses. Add it all up and utilities -- which benefit greatly from the current rules on interest deductibility -- might emerge relatively unscathed, as many have constant capital expenditures.
I think these changes shouldn't ultimately impact credit spreads materially, but will create some meaningful winners and losers among corporate bonds. For example, investment-grade bonds will likely benefit from a limited supply of inventory as companies repatriate dollars from overseas and some find they can more easily switch from issuing debt to using equity financing instead. By contrast, high-yield companies will probably suffer a bit because reduced interest deductibility could meaningfully impact already-stretched bottom lines.
However, these impacts should prove minimal on bond funds, which I think are better than individual bonds for most investors given their diversification and lower entry costs. And as Trump's actual proposal becomes clearer, I'll able to estimate sector impacts more accurately.
Apple(AAPL) - Get Report , Microsoft(MSFT) - Get Report , Cisco(CSCO) - Get Report , Alphabet(GOOGL) - Get Report , Johnson & Johnson(JNJ) - Get Report and Oracle(ORCL) - Get Report are just some of the companies that could benefit from a potential tax holiday, as they have huge hoards of cash overseas.
Who's Paying for All of This?
Of course, unless Congress goes along with Trump's call for a border-adjustment tax (or "BAT"), it's unclear what will generate enough new revenues to offset any meaningful tax cuts. A BAT is unpopular in the Senate, and if it fails to garner sufficient support, expect smaller tax cuts than what the market is hoping for.
My current expectation is that any tax cuts will be watered down, but will have larger deficits serving as the likely funding mechanism. The current administration believes in "trickle-down" economics, and seems more willing than the prior administration to tempt fate by stoking growth and expecting that to generate future taxes that would offset the initial costs.
If that's correct, I expect great pressure on U.S. Treasury and agency bonds, as well as on broad aggregate bond indices that are heavily exposed to Treasuries, agencies and investment-grade corporate bonds. I would pare my overall yield exposure in advance of this possibility. Remember, yields are still very low, so the "opportunity cost" of having less yield exposure isn't problematic.
To supplement income, I would shift some fixed-rate funds into floating-rate investment-grade bonds, leveraged loans or some alternatives like collateralized loan obligations. High-yield bonds should also be OK, as their yield exposure is low.
However, I can't recommend any rate-hedged high-yield fund, as the downside in a "risk-off" trade is simply too dangerous. In a risk-off trade, high-yield bonds would drop in price and your rate hedge would rise, causing double-damage for a risk that isn't all that acute.
Your Game Plan
While we wait for more details on Trump's plan, I'd suggest scaling back on Treasuries, big-corporate bonds and even "agg"-type funds. Conversely, you might want to add to floating-rate funds.
Also look for opportunities to buy municipal-bond funds, with a particular eye on closed-end funds that gap to a wide discount to NAV. I would also have several leveraged-loan and high-yield closed-end funds in mind in case they, too, see rising discounts to NAV.
A full rundown of TheStreet's guide to trading in March can be found here: