EXHIBIT 1: THE POTENTIAL ADVANTAGE OF MOVING PROACTIVELY

In the last two prolonged Fed rate cut cycles, investors didn’t move decisively into ultra-short strategies until well after the cuts started. These late moves may have penalized investors who held onto T-bills for too long while their yields fell with rate cuts.

To emphasize the potential benefits of investing in ultra-short strategies early in the rate-cutting cycle, Exhibit 2 on the following page shows that in previous rate-cutting cycles, ultra-short strategies outperformed T-bills fairly persistently. This is because longer maturity bonds benefit more when yields decline, and the incremental spread from corporate bonds captured additional yield.

EXHIBIT 2: THE HISTORICAL ULTRA-SHORT ADVANTAGE

Ultra-short strategies often outperformed T-bills from 2007 to 2023, but this was especially evident during periods of Fed rate cuts.

4 Questions to Guide Your Move Out of the Fixed Income Curve

While buying ultra-short strategies could be an incremental and simple solution, this may be a good time to take stock more holistically of the fixed income needs within the portfolio. Factors such as timing of cash needs, options to supplement income with yield from credit, investors’ after-tax rate, and revisiting the diversification benefits of fixed income in a portfolio with equities should be considered. The below questions can help guide these decisions for a fixed income allocation.

1. What are your cash needs?

Cash flow needs should be top of mind before significantly cutting T-bill allocations. Mismatches between cash flow requirements and time to maturity may cause losses if bonds are sold before maturity. Investors felt this acutely during the 2022–2023 rate hike cycle. Cash needs can be organized into three buckets related to their time horizons:

• Primary bucket (cash needs in 0–6 months): money market funds or Treasury  bills

 

• Secondary bucket (cash needs in 6–12 months): conservative ultra-short

 

• Tertiary bucket (cash needs in more than 12 months): ultra-short

2. Are your investments tax-efficient?

An investor’s tax rate is a key input to the actual investor experience, which is on an after-tax basis. Municipal bonds offer investors in high tax brackets superior after-tax returns, especially in high-tax states. Exhibit 3 shows that a California investor in the highest tax bracket who earned 3.25% on an in-state municipal bond would need a taxable yield of 7.08% to duplicate that return. Yet investors in lower tax brackets may be better served with taxable bonds. A tax-efficient ultra-short strategy including both municipal and taxable bonds may work to capture an improved after-tax yield.

EXHIBIT 3: MUNICIPAL BONDS MAY HELP INVESTORS IN HIGH TAX BRACKETS

This illustration shows how an investor in California’s top tax bracket may be better off with tax-exempt bonds, such as municipal bonds. Without taking significantly more risk, it may be difficult for those investors to find taxable bonds with the equivalent after-tax yield of a tax-exempt bond.

3. As you move out the curve, are you willing to supplement income with corporate bonds?

While extending the maturity of portfolios in just Treasurys will lock in a yield for longer, the yield likely will be below those of T-bills because of the inverted yield curve. The inclusion of a high quality intermediate investment-grade corporate bond strategy can supplement that yield, potentially adding an additional 0.25% to 0.50% of incremental return over a business cycle. This can fluctuate due to market forces.

4. Do you depend on your fixed income allocation for diversification?

Fixed income can act as a diversifier to equities as historically prices respond to different factors than equities and often in different directions. This is especially the case in an economic slowdown when yields likely will decline in anticipation of rate cuts, benefiting bonds, while equities are negatively impacted by anticipation of lower profits.

We note that in 2022, unanticipated increases in inflation caused both equities and fixed income to decline, undermining the benefit of stock/bond diversification. Yet as inflation becomes contained — which the Fed has said is a requirement to cut rates — we expect bonds to move back to providing diversification versus equities. So if the economy slows more than the market expects, and the stock market declines, fixed income allocations can act as a ballast to a multi-asset portfolio.

Extending to longer duration bonds may increase this benefit. A standard core bond portfolio which includes Treasurys, investment-grade corporate bonds and mortgage-backed securities with about six years of duration has historically been a source of diversification. For investors willing to add a little additional credit risk, core plus strategies can enhance yield with the inclusion of higher yielding sectors like high yield corporate bonds. It is important to note that in isolation longer duration strategies have historically had more volatility than ultra-short strategies.

A Chance to Assess Fixed Income Needs

As the Fed likely will embark on a rate cutting cycle, investors are considering what is next, and when they should take action. History suggests that there are benefits to moving early, particularly with ultra-short strategies. More broadly, before making big moves out of T-bills, investors should take a look at their near-term cash needs, the potential income enhancements to adding corporate bonds, their after-tax yield, and their approach to portfolio diversification. This is a big decision that can make a big impact on investors’ portfolios in the years to come.

— Co-Head of Investment Grade Portfolio Management Bilal Memon; Liquidity Portfolio Manager Kurt Stoeber; Municipal Client Portfolio Manager John P. Ceffalio; Liquidity Portfolio Manager Jing Qin Loo, CFA; Head of Fixed Income Client Portfolio Management Ronit Walny, CFA