One side effect of the near-zero interest rate policy foisted upon investors by global central banks in the post-Global Financial Crisis era was to make bond investing largely an afterthought. When an asset class provides a total return of just +7.0% over a 5½-year period, as the Bloomberg U.S. Aggregate Bond Index did from May 2013-November 2018, there’s not a lot to discuss.
However, as bond investors have come to realize since the beginning of 2022, there’s actually something worse than “dead money” — and that’s DEAD money. After 40 years of bond prices mostly rising as interest rates declined, last year’s spike in rates reminded investors that bonds can lose money quickly in the wrong environment.
We’ve written a few articles over the past two years about inflation, its impact on interest rates, and what those forces mean for bond investments. We’ll touch on a few of those points here, but this article is primarily about how SMI’s Bond Upgrading strategy works and how it fits into an SMI member’s investing toolkit.
A brief history
In SMI’s early days, Bond Upgrading functioned much like Stock Upgrading: bond funds were sorted by type and monthly upgrading decisions were made based on recent momentum within each bond group.
By 2003, we had recognized that despite the added effort of periodically changing funds, Bond Upgrading wasn’t adding much value relative to a static portfolio of bond index funds. The market was roughly 20 years into a prolonged bond bull market marked by disinflation and lower interest rates, and these ever-lower yields made it increasingly difficult for active bond managers to beat the low-cost bond indexes. So, being pragmatic, we simply used index funds for the bond portion of Fund Upgrading portfolios for the next 11 years.
By 2015 though, we began to anticipate the end of what was by then a 30+ year bond bull market. Looking ahead to a less favorable bond environment (that wouldn’t arrive in earnest until last year), we shifted to the hybrid index/active approach Bond Upgrading uses today.
That change has worked out well. Since January 2015 when the current version of Bond Upgrading went into effect, it has gained +19.75% while the Bloomberg U.S. Aggregate index is up just +10.0%.
More important than that longer track record is how the strategy has responded since the shift to higher interest rates began in 2022. This is the danger we were trying to proactively address with the 2015 changes to Bond Upgrading’s methodology. Since January 2022 — the beginning of the worst bond bear market in decades — Bond Upgrading is down only -2.4%, while the broad bond index has lost -10.7%.
Indexing vs. active management
The current Bond Upgrading approach takes half of the bond allocation and splits it evenly between two broad bond index funds — Vanguard Short-Term index (BSV) and Vanguard Intermediate-Term index (BIV). This forms the stable core of the portfolio that will largely go up and down with the overall bond market, although the intentional absence of long-term bonds here helps reduce our risk and volatility substantially.
The other half of the bond allocation is invested based on recent momentum from a universe of both actively managed and passive bond funds. So it’s possible to have 100% of the Bond Upgrading portfolio invested in index funds — if that’s what our momentum rankings call for. At other times, such as now, this half of the portfolio can be allocated to an actively managed bond fund. Whether the “rotating” recommendation is an index fund or an actively managed fund, the process through which it is selected is an active management process.
It’s worth noting that during this recent period of rising interest rates, both halves of the Bond Upgrading portfolio have beaten the broad bond index. Since the beginning of 2022, while the broad bond market index is down -10.7%, the 25%/25% split between our static index holdings (BSV and BIV) is down -6.75%.
The active “Upgraded” portion has done substantially better — this half of the Bond Upgrading portfolio has gained +1.9%. This was achieved by being invested in extremely short-term inflation-protected securities (VTIP) while interest rates were soaring last year, then pivoting to our current actively managed “Unconstrained” selection six months ago.
Spoiler alert: while our current Bond Upgrading methodology has worked quite well — both overall since 2015 and more specifically since rates started rising in 2022 — we’re not opposed to changing this structure if conditions warrant.
One of the more interesting and important questions to be answered after what appears likely to be an oncoming recession is, “What sort of inflationary environment will the next several years present?” If inflation tends to bottom in the 3-4% range in the years ahead, rather than the 1-2% range of the past decade, that will likely have significant implications for bonds. It’s possible we may want to allocate more of our Bond Upgrading portfolio to active managers, or at least an active approach, in that type of higher-rate environment.
Secular vs. cyclical
But that’s a “secular” (long-term) question that probably can’t be answered until we get through the “cyclical” situation directly ahead of us. While the long-term secular trend may have indeed shifted toward higher inflation and higher interest rates, in the short-term, it’s the cyclical that matters. And the balance of evidence still strongly suggests a recession is likely ahead.
Bonds tend to do well in recessionary environments because rates typically fall during recessions. For one thing, the Fed tends to cut short-term interest rates. On that score, the Fed Funds futures markets recently showed investors were anticipating as much as 1.35% of rate cuts over the next year. Longer-term rates usually fall as well during recessions as the prospects for growth and inflation both fall.
This is why SMI has been increasingly positive about the prospects for bonds in recent months. It’s not that we think inflation is necessarily gone for good, or that we’re returning to the era of declining interest rates. On the contrary, we think the secular trend for both inflation and interest rates has likely shifted to both increasing in the years ahead. But before inflation and interest rates go higher over the long term, recession likely takes them lower in the short term first.
A word of caution
Despite the expectation that interest rates are likely to fall as a recession unfolds, we’re not eager to take on the higher risk of long-term bonds right now — within Bond Upgrading, at least. ( SMI’s Dynamic Asset Allocation strategy uses long-term bonds when called for, but it doesn’t own bonds at all times the way Bond Upgrading does.)
One reason we're wary about re-embracing long-term bonds is that this economic cycle has frustrated everyone with how slowly it continues to unfold. With significant rate cuts already priced into the bond market, if this pattern continues and the recession doesn’t arrive as quickly as many expect, there’s potential for rates to adjust back higher as investors realize their assumptions are incorrect about how quickly rate cuts are likely to arrive. Higher interest rates would hurt long-term bonds more than shorter-term bonds.
Second, the specter of higher long-term inflation is looming on the other side of a potential recession. It’s not out of the question that longer-term rates don’t see as much benefit from recessionary factors as usual, because investors keep one eye on the prospect of higher inflation on the horizon. Investors haven’t been through a market transition from sustained low inflation/rates to higher ones in over 50 years, so it’s impossible to know exactly how today’s investors are likely to respond to these changing dynamics.
Bond Upgrading’s process works
Fortunately, we don’t need to know how all of that will shake out on the other side of a potential recession. That’s because we have a process that works and will tell us what steps to take as events unfold.
For now, we continue to suggest diversifying your Bond Upgrading portfolio as we have been: 25% in the Short-Term Index, 25% in the Intermediate-Term Index, and 50% in Bond Upgrading’s active selection. All of these are listed on the Upgrading Recommendations page (scroll down to the Bond Funds section).