July 27, 2023
This year cash has been king in the eyes of the investor, offering better returns than longer-dated bonds as the Fed raised rates. But history suggests that is about to change.
The Fed is either at or near the end of its fastest rate-hiking cycle in history, after raising rates another 25 basis points this week, to a 5.25-5.5% range on federal funds. That means we are close to or at the “peak rate,” a milestone that has historically been followed by the outperformance of intermediate-term bonds versus cash instruments like Treasury bills (T-bills).
Our chart illustrates that after Fed funds peaked in the last three monetary tightening cycles, average annualized returns on five to 10-year muni bonds were higher than Treasury bills on an after-tax basis.
Three years after peak Fed funds, intermediate munis returned over three times more than T-bills, and over five times more after five years.
While intermediate municipal bond yields have already begun to fall, investors can still lock in the highest yields we’ve seen in a decade, and their attraction is twofold: Longer-dated bonds can provide steady cash flow at today’s yields for the next 5-10 years, as well as the potential for capital appreciation from rising bond prices as yields decline.
Staying in cash, however, implies significant reinvestment risk, as maturing Treasury bills must be constantly rolled over at a time when yields are likely trending down. The longer an investor stays in cash, the greater the risk of missing out on attractive yields from intermediate munis.
This is why we caution investors not to overstay their welcome in cash and to invest in longer-duration bonds, to lock in today’s yields.
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