Capital Group portfolio managers John Smet and Karl Zeile discuss opportunities they’re seeing in the year ahead in the taxable and municipal bond markets.
Luke Farrell: John, what is your outlook for U.S. interest rates?
John Smet: Well, Luke, when I look out to 2017, a couple things come to my mind. First of all, rates have become more attractive, and we’ve — in many of our portfolios — begun to buy the five-year and the seven-year. The other thing we have to remember is that higher interest rates and a stronger dollar are a natural drag on U.S. growth. So there is a limit as interest rates rise and the dollar is stronger. [A] stronger dollar hurts people’s ability to export; higher interest rates hurt people’s ability to refinance and buy a house.
So there are limits to this. When we look out, our best-case scenario is that the Fed — while it may raise once or twice this year — currently, the bond market is saying the Fed is going to raise rates three times this year. And we don’t think that’s going to happen. There are some fundamental problems with the economy. We’ve got an economy that still, globally, has got too much debt and, really, in a low-productive environment. So we don‘t think that the economy is going to grow and interest rates are just going to go up, up, up, up. We are beginning to find value in the marketplace. We think there is going to be some inflation. And we’ve been buying some Treasury Inflation-Protected Securities [TIPS], which we think will do quite well.
So that’s a couple things, as we look forward to the advantages of active management, that we can put in our portfolios to benefit from these volatile times.
Luke Farrell: Are there opportunities to position at different points on the yield curve as you think about the Fed raising rates?
John Smet: So you think about the Fed raising rates, and really, what’s happened recently is the short end of the curve has gone up, and the long end has stayed the same. It’s called a flattening of the yield curve. We think the more likely scenario as we move forward is the Fed will be lower for longer, is we won’t get three interest rate increases [and] that the five-year and the two-year and the three-year will actually probably stay where they are. We worry more about what’s going to happen in the long end of the curve. So we think, with inflation coming, that the 30-year may rise and the 10-year may rise more than the five-year, and we’ll get a steepening of the yield curve. So we’re positioned currently for a steepening of the yield curve, with most of our investments in the three-year, five-year and two-year part of the curve.
Luke Farrell: Karl, what is your outlook on municipal bonds given this rate environment?
Karl Zeile: I think the market behavior over the last month or two gives us a good indication of what we should probably expect in bond markets generally, and in municipal bond markets specifically, in the months and years ahead. And one of those key things is volatility.
How do we manage through periods of volatility? Well, there are a couple of things that we can do. The first is — and John talked earlier about the Treasury yield curve — we don’t invest in Treasuries in municipal bond portfolios. At the end of the day, our municipal bond portfolios are built issuer by issuer, bond by bond, in various credit-quality issuers across the rating spectrum.
We continue to have a very strong bias toward revenue bonds over general-obligation bonds, and that will likely continue into 2017. As we think about our overall duration stance, I think the risks are fairly balanced to either side within a municipal bond portfolio.
We have seen in the last month or two, as rates have risen, opportunities to invest in strong ideas coming out of our research team that we weren’t able to invest in before, because bonds are becoming available for purchase. Also we’re able to buy very high-conviction ideas at higher yields. Ultimately, the reason you invest in a municipal bond portfolio is to earn tax-exempt income. Our opportunity now to invest in great credit stories at higher yields means higher and better tax-exempt income for shareholders in our funds. So we will be working through a volatile period, I believe. But in the midst of volatility, I think there is great opportunity for us, as municipal bond portfolio managers.
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