Cash vs. Bonds

With money market fund rates of 5% taxable and over 3.25% tax-exempt (5.15% TEY1), maintaining high cash balances is enticing. However, this is not an attractive long term investment strategy and will be a temporary mirage once rate cuts commence. In this piece we review various micro and macro factors that argue for employing an intermediate term laddered portfolio as a bond portfolio strategy instead of parking funds in the money market.

These factors include (in order from the macro to micro):

  • Restrictive monetary policy
  • A “soft-landing” proxy as insight into future bond returns
  • Historical returns of cash vs. bonds
  • Muni yield-to-worst perspective since the Great Financial Crisis
  • Relative yield across the curve
  • Notion behind the “ladder” portfolio concept

 

Is the Fed Restrictive?

Two main drivers of money supply (along with bank lending) are monetary and fiscal policy. Today fiscal policy is highly stimulative given our budget deficit is expected to reach nearly $2 trillion this year alone, up from the CBO’s prior projection of $1.5 trillion. This increases the money supply, which increases inflationary pressures. The Fed has been combating high levels of inflation by i.) raising short-term rates (via the Fed Funds rate and the interest rate on reserve balances) and ii.) reducing their balance sheet of treasury and mortgage-backed securities. Both these levers typically translate into reducing the rate of loan and money supply growth, thereby reducing inflation.

The crux of this monetary and fiscal policy dance (battle) is which is having a greater impact on the economy? If tight Fed policy is more than offsetting the stimulative fiscal policy, then both growth and inflation will slow.

At the moment, the market and most economists think it’s a net weight, hence the first rate cut is expected to occur at the September 18th meeting, with 2-3 cuts total this year. One indication of restrictive Fed policy is that the Fed Funds rate (5.50%) is well above CPI (3.00%). If this trend continues – inflation moving lower – intermediate rates should remain at current levels or move lower in concert.

How this impacts money market funds: Cash and money market yields are highly correlated with Federal Reserve rate setting policy. As the Fed cut/hike rates, money market fund yields decrease/increase in association to this policy.

 

Bond Returns During the Last “Soft-landing”

The Fed is aiming to orchestrate a “soft-landing” scenario which is an analogy to launching a rate hike cycle (in order to combat inflation) and then be able to land the vessel (i.e. economy) softly without damaging its contents (i.e. high unemployment) with rate cuts. The Fed has succeeded so far in avoiding a recession. The unemployment rate remains low at 4.10% while inflation is 2.6% YoY (PCE2) down from 5.6% in 2022. The Fed’s ultimate goal is in the low 2%s.3

The last time the Fed accomplished this was in 1994-1995 under Alan Greenspan. Bond return s over the next 1-year and 3-year period (from the last rate hike) were very good as inflation petered off and remained stably low.

How this impacts money market funds: This period was a double-edged sword for cash returns as 1) rates were cut so this decreased cash yields and 2) longer bond strategies had attractive total returns, leading to major opportunity cost for those in a cash strategy.

 

Historical Returns of Cash vs. Bonds

The chart largely speaks for itself. Investing in cash/short-term bills (Bloomberg US Treasury Bill Index, June 2024) as a long term strategy is relatively unattractive vs. intermediate term bonds (Bloomberg US Treasury 7-10 Year Index, June 2024).

A reason for this is that yield drives return, and historically speaking, intermediate-to-long duration bonds pay higher yields than shorter term bonds. Today’s yield curve of higher short term rates relative to long term is both a mirage and aberration as this dynamic typically does not last for an extended period.

How this impacts money market funds: Cash/short term strategies have outperformed the longer duration 7-10 Year Index most of the time since this rate hike cycle started. However, if short term rates drop, their potential return will fall in concert, and limited price appreciation will be realized given the short time to maturity. Allocating funds to a slightly higher duration should outperform a cash-based strategy over the long run.

 

Yields at Highs Since Great Financial Crisis

We are at the high point of yields since the financial crisis in 2008-2009. This period was characterized by low-to-stable levels of inflation/growth and easy monetary policy aiming to combat this. Certainly, the next 15-years could play out differently as global economic forces transform.

The Bloomberg Muni Bond Benchmark has a 13.5 year average maturity and yield to worst of 3.59% (July 24th, 2024). This equates to a taxable equivalent yield of 5.69% at the 37% bracket and 5.27% at the 32% bracket. Both these yields are mostly higher than cash yields. This presents an opportunity to lock-in high yields for an extended period of time.

How this impacts money market funds: You can avoid the “cash-trap” of currently high floating rates by locking in intermediate-to-long yields at similar-to-higher levels in today’s market.

 

Relative Yield Offered by Municipal Bonds

The municipal yield curves continues to maintain its “J” shape. In that the front end of the curve (1 to 10 years) is inverted with short term rates higher than the longer portion of this segment. But as you move to the ~13-30 year portion of the curve, yields increase with significant steepness relative to the treasury bond market.

Across the curve we are aiming to lock in a yield to worst of 3.40%, which is like buying a 5.39% taxable bond at the 37% bracket.

5.39% is higher than any point of the treasury curve. So, in essence, implementing a laddered municipal portfolio today both maximizes yield and diversifies interest rate risk.

How this impacts money market funds: The 30-day average yield on your average tax-exempt money market fund is 3.25% or 5.15% taxable equivalent. Some may prefer the higher liquidity offered by this product vs. a 7-year municipal at a 3.40% yield. However, it is possible that a year from now the money market fund may have dropped by over 1% as the Fed cuts rates, while that 7-year bond is now a 6-year bond that you locked in at 3.40%. Furthermore, the bond will have realized price appreciation.

 

Notion Behind the “Ladder” Portfolio Concept

Ultimately, the aim is not necessarily to time the next phase of the rate cycle, but to diversify away from strategies that concentrate a large portion of a portfolio in any one part of the yield curve. Cash is a concentrated bet that yields will remain high or go higher. Certainly, this could happen and this strategy worked well during 2022 and parts of this year when rates increased dramatically.

However, as the Fed cuts rates and the yield curve normalizes, a “laddered” strategy is a higher duration strategy than a money market fund and one that diversifies across a large portion of the yield curve. This means it will i) lock in higher rates for longer and ii.) mitigate exposure to any one interest rate cycle. It is a bet on not making bets.

 

The pivotal input to defining the path of interest rates from here is how inflation plays out. And the defining input into bond portfolio performance from there will be duration. Should inflation continue to calm, higher duration portfolios will outshine lower duration allocations.

Cash has the utmost lowest duration risk on the yield curve.  This certainly comes with its benefits in its flexibility and liquidity. That said, from a bond investment strategy perspective, it is a concentrated bet on accelerating levels of inflation and/or tighter monetary policy (higher short term rates).

 

A ladder portfolio is a more diversified approach for your duration allocation. With both high nominal and relative rates offered by today’s market, we think it sets up very well for medium-to-long run performance.

Please reach out to your Portfolio Manager or Investment Specialist with any questions you may have as it pertains to portfolio positioning or the market in general.

 

Sincerely,

Matt Bernardi
Senior Vice President

 

[1] 30-day average yield of Federated Hermes Municipal Obligations Fund (Ticker: MOSXX); TEY = Taxable equivalent yield calculated at the 37% bracket.

[2] I use PCE as this is the Fed’s preferred measure of inflation. CPI is an alternative measure topped out at 9.1% in 2022 and last posted at 3.00%.

[3] Their explicit goal is 2%. But most believe if PCE prints in the mid-to-low 2%s, while continuing to demonstrate a trend lower in the “core” components, this will allow the Fed to begin cutting the Fed Funds Rate. PCE last printed at 2.6%.