It's been a little over two years since SMI revamped our approach to bond investing. This change was explained in the article, Introducing an Upgrading Approach to Bond Investing that Outperforms the Bond Market. Bonds generally haven't been good performers for the past couple years, so we haven't talked about this new strategy all that much. This has caused some readers to overlook the fact that the new Bond Upgrading strategy has handled the new tightening interest rate environment of the past 16 months quite well.

The need to circle back to this topic was driven home recently when I saw a question posted on our SMI Forums about our current Bond Upgrading recommendation. Specifically, the question was asking why we continue to stick with this particular fund when it hasn't been performing well in the Fund Performance Rankings.

(To briefly review, our Bond Upgrading approach takes half of a bond portfolio and divides it between two index funds which don't change, then takes the other half of the bond portfolio and invests it in a rotating "Upgrading" selection. This is the fund I refer to as the current recommendation in this discussion.)

It's a reasonable question, given that the current recommendation doesn't look so great compared to the other half-dozen options in its specific group (which is the non-traditional bond category).

The key to understanding why we would continue to recommend what looks like a mediocre bond fund within a particular category is found in the change we made to the overall Bond Upgrading strategy two years ago. First, it's worth pointing out that for years SMI did in fact use a form of Upgrading similar to what we still do with stock funds — rank them within their specific peer group, and rotate among the leaders of each group. That approach is basically the foundation of this Forum question: if it isn't even leading its little peer group, why do we still own it?

The answer is that this version of intra-category Upgrading, which has worked well for stocks for many years, has never worked especially well for bonds. Whether that's due to the lower variability in returns between bond funds in the same category, the generally lower returns bond funds earn, or exactly what, we can't say. But we switched away from that form of Upgrading for bonds many years ago (and in fact, relied primarily on indexing for bonds for many years).

When we came back to a Bond Upgrading approach two years ago, it was based on an inter-category approach, rather than an intra-category approach. Or, in non-nerd language, whereas we used to upgrade between funds within the same bond peer groups, we now upgrade between the bond groups themselves.

If this sounds more like our Dynamic Asset Allocation strategy approach, you're on the right track. The bond market is made up of vastly different types of bonds, and our new approach seeks to take advantage of the different way those bond types respond to changes in interest rates, the economy, inflation, and so forth.

That's how we can actually be quite pleased with our latest Bond Upgrading selection, while this reader is looking at it in the rankings and thinking it doesn't look so great. They're looking at that particular group and wondering if there aren't better options there. We're looking at all the bond types and seeing the one we've held is one of the few to not lose money over the past six months that we've owned it.

(Some will naturally wonder why we don't basically do both — upgrade between the categories while also letting the winners within each category rise to the top. The quick answer is including all the funds from the all the categories would result in much more trading within our bond portfolios, and we're not convinced any improvement in results that might come about would be worth it. People generally don't like a lot of activity and excitement within their bond portfolios. Our current system has been tuned with the goal of minimizing turnover and the number of trades to what we consider to be a reasonable level.)

Consider these returns of Vanguard bond funds of the alternative bond types we could have been in over the past six months:

Long-term -5.90%
Intermediate-term -3.16%
Short-term -0.76%
GNMA -1.84%
Inflation-Protected -0.80%
High-Yield 3.52%

Only one of those groups has been able to do what our current Bond Upgrading has done over the past six months — generate a positive return! And while the high-yield group has been the star of the bond universe, it has also courted tremendous risk in the process, as high-yield bonds are much more highly correlated with stocks than other bond types. With the stock market looking potentially overvalued, it's hard to be enthusiastic about also hitching our bond portfolios to that same cart.

The current Federal Reserve rate tightening cycle began in December of 2015, giving us our first true test of the new Bond Upgrading system. After all, it was with a forward-eye on the inevitability of interest rates rising eventually that we made this change to how we invest in bonds. So it's encouraging that the new Bond Upgrading approach gained 3.6% last year, while the U.S. Aggregate Bond Index was up just 2.5%

While rates didn't tighten much in 2016 (just one additional hike in Dec 2016 followed the initial Dec 2015 hike), last week they were ratcheted higher for a third time, with plans for additional hikes this year. The Bond Upgrading fund we're in now is very opportunistic, but conservatively invested at present. That's worked well in recent months, allowing SMI readers to avoid losses in this portion of their bond portfolios.

The bond landscape is a tricky environment to navigate at present, but we think we've got a good system to handle it. Our core bond holdings (which don't change) will eventually start to benefit from the higher interest rates starting to filter out through the market as the Fed slowly raises rates. Along the way, we expect there will be opportunities to profit. But at other times, such as the past six months, it's appropriate to just keep our head down and avoid losing money.

We've been successful in doing that lately with this upgrading selection, and that's why we're pleased with it, despite the fact that some of its category peers may have earned a bit more lately. There's a wide range of risk behavior within the non-traditional bond group, and we like the approach of the holding we have. More importantly, as a representative of a particular type of bond investing, we've been right where we want to be: making money on our bond holding while most bond types were losing, without taking on the substantial risks that high-yield bonds represent at this point in the investment cycle. We'll leave the home run swings for strategies like Sector Rotation, and be satisfied stringing together a bunch of safer singles within our bond portfolio.