The U.S. bond market took no prisoners last year, which might have been its worst year ever. Blame it on the Federal Reserve, which raised short-term interest rates seven times in 2022 as it struggled to vanquish an annual inflation rate that hit 9.1% in June. Higher interest rates pressured bond prices, which move inversely to yields, leading to big losses across fixed-income portfolios. The
iShares Core U.S. Aggregate Bond
exchange-traded fund was down 13%, including interest payments.
For some perspective on the bond market, and a 2023 forecast, Barron’s turned to Gibson Smith, a seasoned fixed-income investor who founded Denver-based Smith Capital Investors in 2018. His 30-plus years in the business also include 15 years at nearby Janus Capital Management, where he served as chief investment officer of the fixed-income division and a fund manager. Smith’s firm subadvises about $3 billion of mutual funds, including the $1.9 billion
ALPS/Smith Total Return Bond
fund (ticker: SMTRX), which returned minus 12.4% last year, but which has bounced back this year with a gain of 2%.
Smith, 55, had plenty to share about the bond market in a Feb. 9 phone call and a follow-up discussion this past week. He also had a few names to recommend—notably, the debt of
(BA). An edited version of our conversations follows.
Barron’s: Last year was a year to forget across the bond market. How is 2023 shaping up?
Gibson Smith: This is one of the most attractive periods I’ve seen in the bond market in almost a decade. Thanks to the significant repricing of yields and risk assets in 2022, the bond market has returned to yield levels of 5%, 6%, 7%. The market is set up for potentially good returns over the next 12 to 24 months. We could see high-single digit, if not low-double digit-type returns across the board in fixed income if things play out as we anticipate in 2023.
What are you anticipating?
The Fed’s aggressiveness in raising interest rates and reducing its balance sheet—what we call quantitative tightening—is designed to lower inflation. Ultimately, it is going to slow the growth trajectory of the economy. As the economy slows, the bond market will look more attractive. We could see yields start to reverse course and decline as the year progresses, providing better total returns for bond investors.
Does the Fed have to pause its rate hikes, or even start to cut rates, for that to happen?
It has to pause eventually. The Fed isn’t going to keep raising rates indefinitely. It has done a lot of damage to the economy. This is the most aggressive tightening campaign we’ve seen in 40 years, and in one of the shortest time periods.
The yield on the 10-year U.S. Treasury note hit a 52-week closing high of 4.23% in October. It then fell back to around 3.4%, only to rally back to 3.75% recently. What is the bond market signaling?
The rally from October through the end of January was largely driven by money coming back into the bond market. For most investors, there has been a solid hatred of the bond market because of the low yields and the risk last year. But when yields started moving up toward the 4% level, we started seeing money come back into the market. That drove the 10-year Treasury yield down by 65 to 75 basis points. [A basis point is 1/100th of a percentage point.]
People are trying to lock in those higher yields. However, some of the recent data, particularly after the stronger-than-expected nonfarm payrolls report on Feb. 3, call into question whether the economy is really slowing. That has led to some of the volatility we’ve seen in the bond market over the past few weeks, and to higher yields.
You have been cautious about investing too heavily at the front end of the yield curve, or in short-dated bonds, even though yields have risen. Why is that?
The yields at the front of the [Treasury yield] curve—on a one-year Treasury bill or even short-dated corporate bonds—are attractive compared with the yields available on 10-year Treasuries or even 30-year Treasuries. So, there tends to be a bias among investors toward wanting to grab those yields.
We remind investors that those yields are only there for a short period of time. If you buy a one-year bill, at the end of that year the yield is gone, and you will have to reinvest in a market that may have lower yields. If you believe the economy is going to slow and inflation is going to recede, the bond market will present much greater returns further out the curve—for example, from five-, 10-, 20-, and maybe even 30-year bonds.
I say this all the time: Duration, or the price sensitivity of a bond to changes in interest rates, is a recession’s best friend. As yields go down, prices go up, and vice versa. The double-digit returns available today are largely predicated on interest rates declining and spreads tightening.
Where will the 10-year Treasury yield be at the end of 2023?
Predicting that is very difficult. I expect the yield will be lower than it is today as inflation declines and the economy starts to slow—and probably slow more aggressively than the current consensus view.
How do you think the Fed has performed in trying to get inflation under control?
The Fed got us into the situation. They have to get us out of it, and have no choice but to be vigilant on inflation. They have to continue hiking rates and address their balance sheet. That the Fed’s balance sheet peaked at $9 trillion of Treasuries and mortgage-backed securities creates a lot of dislocations. And it creates a lot of, shall we say, false pricings in the bond market when that amount of securities has been held back from the market.
Was the Fed too late in getting a grip on inflation?
Yes. Fed Chairman Jerome Powell was a little too complacent, particularly toward the end of Covid. The Fed expanded its balance sheet by too much and kept rates too low for too long. The consequences are what we are dealing with now.
Why do you expect bond market volatility to continue?
There is still a lot of uncertainty on the horizon—economically and geopolitically. We still need to work through some of the imbalances and misallocation of capital that took place during Covid. Companies took on too much debt. This won’t be a one-way trade as in 2019, when rates precipitously declined throughout the year. This is going to take place in fits and starts. But within those fits and starts, there will be really great opportunities for fixed-income investors.
Where are the opportunities now?
We have a barbell approach in our portfolios. We own significant exposure at the front end of the curve—bonds that mature in five years or less—where we can garner those attractive yields. We balance that with some exposure to 20- and 30-year Treasuries. We believe the latter will provide insurance against some of the volatility but also react favorably to a declining inflation rate over time.
I would imagine that as time passes, you will see us taking profits in those longer-dated securities and moving toward the middle of the Treasury curve, focusing on securities with maturities of five to 10 years. As the Fed pauses and lowers rates in the future, the yield curve will start to normalize, with the front end—say, a two-year Treasury—declining in yield, and the long end of the market moving up in yield. The middle of the curve offers a way to get exposure to the bond market that is close to the Bloomberg U.S. Aggregate Bond index’s duration.
What looks attractive in corporate bonds?
We like both investment-grade and high-yield bonds, but it isn’t about liking the market; it’s about liking certain companies. Our philosophy is built around bottom-up fundamental research and individual security selection. We look for companies that are fundamentally improving and generating free cash flow, and whose management teams are incentivized to use free cash flow to pay down debt.
What are some of your top holdings?
Some sectors still have strong tailwinds in terms of profitability and free-cash-flow generation. We are overweight some of them, including autos. General Motors and Ford Motor are still benefiting from low inventory for new autos and strong pricing. In our view, Ford is on the cusp of moving back to an investment-grade credit rating. It carries a BB+ rating from S&P Global, just below BBB-, which is investment grade.
What about General Motors?
Its debt is investment grade. GM continues to look at its margin structure and generate great free cash flow. Its adjusted automotive free cash flow totaled $10.5 billion last year, up from $2.6 billion in 2021. GM has struck a balance between shareholder-friendly activity, including reinstating the quarterly dividend last summer, and improving its balance sheet.
You also hold some of Boeing’s debt. What is the attraction?
Boeing’s debt rating is at the low end of investment grade, but the company has been paying down a lot of debt. It is a somewhat controversial holding. Some people still don’t believe that Boeing is through the worst of its problems [including fallout from the Boeing 737 Max crashes in 2018 and 2019]. But the company is improving its margins and dedicating its cash flow to paying down debt. Its long-term debt was $51.8 billion at the end of 2022, compared with $56.8 billion a year earlier. It also announced a huge order on Feb. 14 from Air India, a pleasant surprise.
What other parts of the bond market look attractive?
We also like mortgages, in particular agency mortgages such as those packaged in collateralized mortgage obligations, or CMOs. Their yields range from about 4.75% to 6%. Many are priced at 91 or 92 cents on the dollar. Even though mortgage rates are pretty high right now, people still move from one city to another. They change jobs, they get divorced, or something else happens that creates a sale of a home and ultimately a prepayment. So the mortgage investor gets a higher coupon, and some prepayments that come back to them at par.
Write to Lawrence C. Strauss at firstname.lastname@example.org