Bonds offer a lot of bargains. Now's the time to buy.

Last year, which could have been its worst year ever, the American bond market showed no mercy. It's the fault of the Federal Reserve, which struggled to control an annual inflation rate that reached 9.1% in June and increased short-term interest rates seven times in 2022. Bond prices were under pressure due to rising interest rates because they move inversely to yields, resulting in significant losses for fixed-income portfolios. Including interest payments, the iShares Core U.S. Aggregate Bond exchange-traded fundAGG -0.23% fell 13%.

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Barron's went to Gibson Smith, an experienced fixed-income investor who established Denver-based Smith Capital Investors in 2018, for insight into the bond market and a 2023 prognosis. His more than 30 years in the industry also include 15 years spent close by at Janus Capital Management, where he worked as a fund manager and the chief investment officer of the fixed-income division. The $1.9 billion ALPS/Smith Total Return BondSMTRX -0.21% fund (ticker: SMTRX), which returned minus 12.4% last year but has recovered this year with a gain of 2%, is one of the $3 billion worth of mutual funds that Smith's business subadvisers.

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During a phone chat on February 9 and a subsequent conversation this past week, Smith, 55, had a lot to say about the bond market. He also suggested a few names, most notably the debt of Boeing, General Motors, and Ford Motor (F) (BA). What follows is a condensed version of our conversations.

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Gibson Smith: In over a decade, this is one of the bond market's most appealing times. The bond market has returned to yield levels of 5%, 6%, and 7% as a result of the massive repricing of yields and risk assets in 2022. For the next 12 to 24 months, the market is poised to offer potential good returns. If events unfold as predicted in 2023, fixed income returns could range from high single digits to low double digits.

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What are you looking forward to?

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The Fed's aggressive quantitative tightening strategy, which involves hiking interest rates and shrinking its balance sheet, aims to bring down inflation. In the end, it will slow the economy's trajectory of growth. With a slowing economy, the bond market will seem more appealing. As the year goes on, rates may start to reverse course and decrease, giving bond investors stronger total returns.

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Would that require the Fed to stop raising rates or perhaps to start cutting them?

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It must finally stop. Rate increases by the Fed won't last indefinitely. The economy has suffered a great deal because of it. In one of the smallest amounts of time, this tightening campaign is the most intense we've seen in the last 40 years.

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The 10-year U.S. Treasury note yield In October, the yield on Treasury notes closed at a 52-week high of 4.23%. After that, it dropped to about 3.4% before lately rising to 3.75%. What message does the bond market send?

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The re-entry of capital into the bond market from October to the end of January was a major factor in the surge. Due to the low yields and risk last year, the bond market has generally been detested by investors. Yet as yields increased toward the 4% threshold, we noticed money returning to the market. As a result, the yield on the 10-year Treasury fell by 65 to 75 basis points. [One-hundredth of a percentage point, or a basis point,]

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In order to lock in those higher yields, people are trying. But some recent information raises doubts about whether the economy is actually weakening, particularly in the wake of the stronger-than-anticipated nonfarm payrolls report released on February 3. The bond market has experienced some volatility recently, which has resulted in higher rates.

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Despite the fact that yields have increased, you have been careful to avoid making excessive investments in short-dated bonds or near the front of the yield curve. How come?

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As compared to the returns offered on 10-year or even 30-year Treasuries, the yields at the front of the [Treasury yield] curve—on a one-year Treasury bill or even short-dated corporate bonds—are appealing. Investors therefore frequently have a bias toward seeking to seize those yields.

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We want to warn investors that those yields are only available temporarily. If you purchase a one-year bill, the yield will disappear at the end of the year, forcing you to reinvest in a market where rates may be lower. The bond market will offer significantly higher returns further down the curve, such as from five-, ten-, twenty-, and thirty-year bonds, if you anticipate that the economy will slow and that inflation will decline.

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I frequently remark that duration, or a bond's price sensitivity to interest rate movements, is a recession's best ally. Prices rise as yields decline and vice versa. Today's double-digit returns are mostly dependent on spread tightening and lowering interest rates.

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At the end of 2023, where will the yield on the 10-year Treasury be?

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That is really difficult to predict. As inflation decreases and the economy begins to slow—and possibly more aggressively than the current conventional view—I anticipate that the yield will be lower than it is now.

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What role does the Fed play in attempting to manage inflation, in your opinion?

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We were put in this situation by the Fed. They have no choice but to keep an eye on inflation in order to rescue us. They must fix their balance sheet and keep raising rates. There are many disruptions caused by the fact that the Fed's balance sheet peaked at $9 trillion in Treasuries and mortgage-backed securities. And when that quantity of securities is withheld from the market, it leads to a great deal of, shall we say, erroneous prices in the bond market.

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Was it too late for the Fed to control inflation?

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Yes. Jerome Powell, the chairman of the Fed, was a touch too relaxed, especially near the end of Covid. The Fed overextended its balance sheet and held interest rates too low for an extended period of time. We are currently coping with the effects.

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Why do you think the bond market will remain volatile?

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The future still holds a lot of economic and geopolitical uncertainties. Several of the inequities and capital misallocations that occurred during Covid still need to be addressed. Businesses incurred excessive debt. It won't be a one-way trade like in 2019 when rates sharply dropped all year. Fits and starts will characterize this. But, there will be excellent chances for fixed-income investors within those fits and starts.

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Where are the chances right now?

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In our portfolios, we use a barbell strategy. We have a sizeable exposure to bonds with maturities of five years or less in the front end of the curve, where we may obtain such alluring rates. We counteract it by having a small exposure to 20- and 30-year Treasury bonds. The latter, in our opinion, will both perform favorably in response to a gradual decline in inflation while also offering insurance against some of the volatility.

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As time goes on, I predict that you will see us selling off those longer-dated securities and shifting our attention to securities with maturities between five and ten years, or near the center of the Treasury curve. Further rate cuts by the Fed will cause the yield curve to begin to normalize, with the front end of the market—say, let's a two-year Treasury—seeing a decline in yield and the long end of the market experiencing an increase in yield. The center of the curve provides access to the bond market at a duration that is comparable to that of the Bloomberg U.S. Aggregate Bond index.

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What about corporate bonds seems appealing?

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Investment-grade and high-yield bonds both appeals to us, but this isn't because we enjoy the market; it's because we favor particular companies. Our philosophy is based on individual security selection and bottom-up fundamental research. We look for companies whose management teams are motivated to use free cash flow to reduce debt and are fundamentally improving and generating free cash flow.

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What top holdings do you have?

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Several industries continue to enjoy favorable profitability and free cash-flow generating trends. Several of them, including automobiles, are overweight due to us. Low new car inventories and high prices continue to be advantageous for General Motors and Ford Motor. According to us, Ford's credit rating is about to return to investment-grade status. S&P Global has given it a BB+ rating, which is barely above investment grade BBB-.

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Is General Motors a factor?

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Investment grade describes its debt. GM keeps examining its margin structure while producing excellent free cash flow. Its adjusted automotive free cash flow increased from $2.6 billion in 2021 to $10.5 billion last year. In order to balance shareholder-friendly actions with strengthening its financial sheet, GM reinstated the quarterly dividend last summer.

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You are also a debtor to Boeing. What draws people in?

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Although Boeing has been making significant debt reductions, their debt rating is at the lower end of the investment grade. It's a holding that has generated some debate. Several people continue to doubt that Boeing has overcome its major issues, especially the effects of the Boeing 737 Max crashes in 2018 and 2019. However, the business is increasing its margins and using its cash flow to reduce debt. By the end of 2022, its long-term debt had decreased to $51.8 billion from $56.8 billion the previous year. On February 14, it also revealed a sizable purchase from Air India, which was a welcome surprise.

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Which other areas of the bond market seem promising?

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We also enjoy mortgages, especially agency mortgages like those bundled in CMOs, or collateralized mortgage obligations. Their yields fluctuate between 4.75% and 6%. A lot of them are sold for 91 or 92 cents on the dollar. People continue to relocate from one place to another despite the current high mortgage rates. They have a change in employment, a divorce, or another event that results in the sale of their home and, ultimately, a prepayment. The mortgage investor thus receives a higher yield as well as some prepayments that are refunded at par.

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