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For bond investors taking advantage of the high yields available in cash, now is the time to buy bonds.


For over a year, cash has been a comfortable place to sit for many investors, with cash earning over 5%, its highest in over a decade. Meanwhile, after a rough start to 2023, bonds delivered positive total returns for the year, aided by a sharp move lower in Treasury yields. The rally in bonds began in early November as inflation continued to moderate, and it gathered even more momentum after an unexpected pivot from the Federal Reserve at its December policy meeting.


With the federal funds rate having peaked, investors in cash should consider extending duration by reallocating into short- to intermediate-term bonds and bond funds. Though the Fed has yet to declare victory in the fight against inflation, the central bank has signaled rate cuts are on the horizon in 2024 as long as disinflation continues. As a result, investors have a narrow window to take advantage of historically attractive yields and potential capital appreciation in the bond market.


Staying in Cash Carries Risks  


Exhibit 1 shows the expected path of the federal funds rate as well as the 1-year Treasury bill (a proxy for cash), which are highly correlated. The federal funds rate is expected to decline to 3.6% by the end of 2025. Although reinvestment risk has not been a primary concern for investors since the Fed started raising rates, that is starting to change.  



An Attractive Entry Point


Although Treasury yields have recently declined, they remain near decade highs. Treasuries across the curve offer yields between 3.90% and 4.35%, and investment grade corporate bonds offer an average yield of 5.20%. Meanwhile, yields on an actively managed, high-quality intermediate municipal bond portfolio currently range from 3.00% to 3.25%. For individuals living in a high-income tax state, such as New York, New Jersey or California, that’s about 6.25% on a tax-equivalent basis for an investor in the top tax bracket.


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. 


A move lower in yields of 50 basis points should produce positive returns of 3.3% to 3.8% for municipal bonds, compared to 2.7% for cash. For an investor in the highest income tax bracket, an intermediate municipal bond can generate an attractive after-tax return of 4.8% given a 100 basis point (or 1%) move in yields. That’s almost twice as much as cash. If yields hold steady, annualized returns on munis over the next two years should be in the range of 2.7% to 2.9% depending on the maturity. Even if yields were to increase, returns would remain positive as higher starting yields help to offset any price depreciation. 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 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 three times the return of 1-year Treasury bills on an after-tax basis. 



Don’t Miss Out on Today’s Higher 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. 



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