If tax rates increase, as is expected, the post-tax cost of equity will rise and the post-tax cost of debt will drop, everything else kept equal. With regard to debt in particular, this means that corporations will issue less equity and more debt going forward, and they accept higher yields on the debt that is issued. In addition, investors will demand higher yields b/c they would otherwise see less yield post-tax. These effects will be amplified with higher-yield debt since the effect is a % of current yield. Thus, I expect credit spreads to widen, w/ junk bonds underperforming investment-grade. The benefit of structuring the short junk bonds position as a pair against investment-grade instead of naked or against something else is that the long investment-grade position hedges out much of the impact on junk-bond prices that I dont wish to bet on, such as general risk appetite or in/outflows to/from corporates in general. I am using the ETFs JNK and LQD to put on the trade, and I'm taking a larger position in LQD than JNK b/c JNK's "beta" is larger.
This trade would have worked briefly in early Nov when the market was also panicking out of numerous high-dividend equity stocks. Bond spreads have tightened and high-dividend stocks have bounced for the most part ever since until the last couple days. My bet is that the market has been ignoring the potential effects of the fiscal cliff for too many weeks with respect to these trade categories. Particularly w/ respect to bond risk spreads, I believe that the risk of a large tightening is limited even should politicians come to an agreement to restrict tax increases even somewhat, so I plan on taking this particular position through any upcoming political meetings, votes, decision-making sessions, etc.
In addition, the cliff will bring about a weakened economy, so this should also contribute towards widening spreads. Of course, this trade has negative carry, so I don't want to hold too long, but perhaps several weeks or months would be appropriate to allow the markets sufficient time to price in economic deterioration and changes in post-tax cost of debt. This might be a kind of delayed sleeper trade that works later than the other fiscal-cliff-type trades and wont work until corporate CFOs start actually raising more capital and the bond folks start seeing bond issuance suddenly spike and think of this trade.
I had written earlier about looking to short private equity firms due to risk that their carried interest benefits will be cut. However, I neglected at that time to consider that they'll have far more buyout opportunities opened to them due to the fact that companies would be able to handle higher debt leverage ratios with the imminent reduction in cost of debt. That could be a good reason why many buyout firms have outperformed lately.
Muni bonds have sold off in the last couple weeks ever since they became a target for a tax loophole elimination--namely, that rich investors will have to start paying taxes on muni dividends. While that change to muni bonds is drastic, this is the same kind of consequence that should take place on a subtler scale to credit spreads.