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, it has been another tough year for bond holders. Yields on longer-dated Treasuries (> 1 year) have pushed higher, with the 10-year Treasury reaching just over 5% for the first time since 2007. This has transpired as U.S. economic growth has surprised to the upside, the Fed continues to signal higher for longer rates, and concerns over U.S. debt levels persist alongside worries surrounding the growing percent of the budget allocated to paying interest on the national debt.
With rates higher for longer, and the bond market selloff likely behind us, investors in cash should consider extending duration by reallocating into short to intermediate term bonds and bond funds. Though the fight against inflation may not be over, we believe we are at or near peak interest rates, and investors have a narrow window to take advantage of the attractive yields currently available in the bond market.
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. Even if we see one more rate hike, the federal funds rate is expected to decline to 2.9% by the end of 2025. Although reinvestment risk has not been a primary concern for investors since the Fed started raising rates, that could soon change.
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.
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.
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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