One of the most discussed financial topics of the past couple years is the seemingly imminent end of the 30+ year bull market in bonds. Most of today's investors have experienced only good times in the bond market, which is part of the reason why huge amounts of money have moved from the stock market to the bond market since the stock market cratered in 2008 (the other significant reason is the aging Boomers, who are appropriately turning to bonds as they age).
But times, they are a-changing. With interest rates pushed to unnaturally low levels by central banks around the world, and with those efforts already ended here in the U.S., the discussion has officially shifted to when interest rates will start heading higher, and what that will mean for bonds.
If you're new to the topic of bonds, let me point you to a helpful primer. Bond Basics You Need to Know walks through the nuts and bolts of how bonds work, the crucial relationship between bond prices and interest rates, and more. I'm not going to cover that ground again here, but understanding it will make the rest of this article easier to understand.
Recently, a reader asked how our new Bond Upgrading strategy will perform if interest rates start to rise. They went on to ask if it would be better for an investor to just be in SMI's Dynamic Asset Allocation strategy instead, so they could automatically be shifted out of bonds, or if Bond Upgrading would be conservative enough to mitigate losses should interest rates start turning up.
Those are good questions that I'm sure others are wondering about as well. I thought it would be helpful to outline the two-fold approach SMI has taken to prepare readers for the (seemingly) inevitable rise of interest rates.
It's worth repeating the fact that the Dynamic Asset Allocation strategy was born out of a desire to be less reliant on a static bond portfolio for portfolio stability. We were looking ahead to what seemed like a period of inevitable rising interest rates and were specifically looking for ways to counteract that issue.
We had a very similar goal in mind when designing the Bond Upgrading strategy — build it in such a way that it should be able to respond well to rising interest rates. The difference being, of course, that bond upgrading would attempt to do so strictly within the confines of the bond asset class, whereas DAA could completely exit the bond asset class.
So the first prong of SMI's strategy to deal with rising interest rates is centered around DAA, which was designed specifically to reduce our overall reliance on bonds while still maintaining a low risk profile. We've spent considerable time and effort over the two-and-a-half years since DAA was rolled out teaching SMI readers how to incorporate it into their portfolios in such a way as to maintain (or even reduce) the risk profile of their portfolio, but to do so with a reduced reliance on bonds overall.
An example will help. Higher Returns With Less Risk: The Best Combinations of SMI’s Most Popular Strategies explains the rationale behind using a 50% DAA, 40% Upgrading, 10% Sector Rotation portfolio allocation, detailing the substantial risk-reducing properties of DAA. Someone who opts for that 50/40/10 strategy split is effectively reducing the "static bond" portion of their portfolio to just the bond portion of the 40% Upgrading component. If they were primarily using Upgrading before, and had say, a 50-50 stock-bond allocation before, shifting to 50/40/10 will make them significantly less reliant on bonds. Whereas roughly half of their portfolio was allocated to bonds before, now their 50% bond allocation is reduced to effectively 20% of their total portfolio (50% of their 40% Upgrading allocation). Yes, DAA may at times call for additional bond holdings, but presumably this will only happen during periods when bonds are performing reasonably well. (And even then, their bond allocation would swell to just ~37% of their total portfolio, as opposed to the 50% that was fixed in bonds during good times and bad before.)
While we like the idea of reducing a fixed allocation to bonds, we're less enthused about completely eliminating it. For many investors, there's still a place for a fixed bond allocation — if for no other reason than you've got to put the money somewhere. Taking the 20% fixed allocation to bonds in the above example and moving it into more equities, even if it's through a larger DAA allocation, doesn't seem wise.
That's where the new Bond Upgrading approach comes in. Simply put, its flexibility produces a better approach to investing in bonds than we were using before. Designing it to respond to what the bond market's current trend and providing it with the option to move into short-term, unconstrained, and other types of "defensive" bonds should allow the strategy to respond much better to rising rates.
That said, it's impossible to say how bond upgrading will actually perform in the future. What we like about its structure is it has the opportunity to be more conservative if conditions warrant that. It also has the ability to be more aggressive if conditions warrant that. The key is it is built to be more flexible and responsive to changes in interest rates, which was something the old system lacked. We didn't particularly need that flexibility when interest rates were dropping consistently for over 30 years. Now we do.
So to recap, SMI has made two significant changes for bond investors in the past three years. First, we've developed and explained a framework for lowering our readers' overall reliance on bonds. This was done via the creation of DAA and the development of new "model portfolio" ideas like the 50/40/10 combination. Second, we improved the way we invest the remaining bond allocation by building flexibility and more conservative options into the new bond upgrading approach. We think this combination should serve readers well if/when interest rates finally do start climbing.