An Attractive Entry Point

The one silver lining to aggressive Fed tightening and rate volatility is bonds now offer some of the highest yields we’ve seen in over a decade. Treasuries across the curve offer yields between 4.5% and 4.9%, and investment grade corporate bonds offer an average yield of 6%. Meanwhile, yields on 10-year AAA municipal bonds are 3.3%. For individuals living in a high income tax state, such as New York, New Jersey or California, that’s about 6.7% on a tax-equivalent basis for an investor in the top tax bracket. If they are willing to take a little more risk, investors can receive up to 25 to 50 basis points in additional yield for municipal bonds rated lower than single A.  

A bond’s current yield is not the sole consideration when investing; the underlying value upon purchase matters just as much. There are two components of bond returns: income from payments and changes in price. Bonds pay a fixed interest rate or coupon, which becomes more attractive when interest rates fall, driving up demand and the price of the bond. However, the value of a bond decreases when interest rates rise. If the economy slows over the coming quarters, as we expect, and interest rates decline, these higher starting yields, along with appreciation, will deliver attractive total returns. 

As Exhibit 2 illustrates, we believe municipal bonds currently offer an attractive risk/reward trade-off for long-term investors. The chart displays potential annualized total returns for municipal bonds of different short and intermediate maturities compared to cash, considering a change in yields over the next 24 months. If yields hold steady, annualized returns on munis over the next two years should be in the range of 3.7% to 4.1% depending on the maturity. This compares to an after-tax yield of 3% in cash, as measured by a 1-year Treasury bill. 

A move lower in yields of 50 basis points should produce positive returns of 3.8% to 5% for municipal bonds, compared to 3% for cash. For an investor in the highest income tax bracket, an intermediate municipal bond can generate an attractive after-tax return of 6% given a 100 basis point (or 1%) move in yields. That’s over two times that of cash. Even a 50 basis point move higher in yields from current levels would produce returns in excess of cash because of the yield when purchased. Importantly, with attractive yields available across the municipal yield curve, investors do not need to take on much more risk to outperform cash.

Take Advantage of Peak Rates  

History suggests that when the Fed is close to or at peak rates, short- and intermediate-term bonds and bond funds beat cash. In past tightening cycles, yields have typically fallen in the 12 months following peak federal funds rates. As seen in Exhibit 3, in the 1, 3 and 5 years that followed peak fed funds rates, average annualized returns for short-term bonds (1-5 years) and intermediate-term bonds (5-10 years) outperformed 1-year Treasury bills on an after-tax basis due to higher starting yields. Over a five-year period, intermediate-term bonds delivered more than five times the return of 1-year Treasury bills on an after-tax basis. 

Don’t Miss Out on Today’s High Bond Yields

Although interest rate volatility may persist, the longer an investor stays in cash, the greater the risk of missing out on today’s higher bond yields. We offer a range of actively managed fixed income solutions, which can be customized to your risk tolerance and goals, and they hold the potential to outperform cash over the long run. If you are sitting in cash, it may be time to find another chair.