Junk bond ETFs has a muted run in 2017 with popular funds SPDR Barclays High Yield Bond ETF (JNK Quick QuoteJNK - Free Report) andiShares iBoxx $ High Yield Corporate Bond ETF (HYG Quick QuoteHYG - Free Report) returning only 0.2% in the last one year (as of Jan 10, 2018) against 20.8% gains for the S&P 500 index.

Though junk bonds tend to put up a similar performance as that of equities, last year opposed the fact.

This makes it more important to have a look at how junk bond ETFs could perform this year. While there is strength latent in the space, roadblocks are also waiting.

Oil Price Recovery: A Boon

Last year, oil price volatility weighed on the space, especially on energy bonds. This was because the U.S. energy companies spread their presence widely to the high-yield bond market to materialize the shale-oil boom. Thus, fears of their default amid oil price pressure prompted junk bond sell-offs (read: Oil Sees Strong Start to 2018 in 4 Years: ETFs to Play).

Now, oil prices have made a sharp comeback to close out the year 2017, though the whole year has not been so smooth. West Texas Intermediate futures jumped over $60 a barrel in late December for the first time since 2015. In a nutshell, if oil prices can maintain the uptrend throughout 2018, junk bond ETFs can see some recovery (read: 3 Sector ETFs for 2018).

GOP Tax Plan is Negative for Junk Bonds

While the tax-cut bill was a boon to the stock market, a third of the highly-leveraged companies may see their profits decline based on what congressional Republicans do. As per Moody’s Investors Service, based on the latest tax bill “full upfront capital expenditure deductibility and the limitation on interest deductibility” may put junk-rated companies at risk.

As per an article published on thestreet.com, the previous law entailed full deduction of interest paid. The new law will hold companies back from relying too much on debt. There is a provision in the tax blueprint that calls for limiting “deductions to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, and 30% of EBIT after that (read: Tax Reform: A Boon or Bane for Small-Cap ETFs?).”

Bond market veteran Jeff Gundlach indicated that the tax plan’s changes to interest-rate deductibility could hurt the $1.5 trillion junk bond market. Companies that normally issue high-interest debt are inclined to have highly leveraged balance sheets and look toward of benefiting from deducting their interest expenses from taxable earnings. If these tax benefits are limited, the risk of the most indebted issuers defaulting would be higher.

There is more to the story. As per an article published on CNBC.com, “the tax plan would raise taxes in states like California, New York and New Jersey, which are already high tax-paying states. Gundlach said it would likely make people in those states less willing to buy stocks and risk assets.”

Rising Bond Yields

The start of 2018 has shaken the fixed income world thanks to the steep rise in yields. As of Jan 10, 2018, the yield on the benchmark 10-year Treasury note was 2.55% while the year started with a benchmark bond yield of 2.46%. Several developed global central banks are eyeing policy tightening this year. The tendency has kept U.S. Treasury yields on an upward trajectory.

Investors should note that the Fed has enacted five rate hikes since December 2015. Though benchmark Treasury bond yields remained at subdued levels throughout 2017, many Fed officials also gave hawkish comments recently. Junk bond ETFs, known for higher yields, are likely to underperform in a rising rate environment.

Want key ETF info delivered straight to your inbox?

Zacks’ free Fund Newsletter will brief you on top news and analysis, as well as top-performing ETFs, each week. Get it free >>