Forecasts of short-term rates driven by Fed policy have been ever changing, but after the recent inflation print, it seems as though Fed Funds may have peaked. Investors looking to dip their toes back into bonds may be able to do so through short duration products. Longer duration fixed income has seen significant inflows, but many aren’t ready to add that much duration to their portfolios. Luckily for them, going further out on the yield curve doesn’t necessarily increase income potential. As shown in the US Treasury yield curve below, currently yields in the front end of the curve are greater than in the belly.
Shorter maturities have higher yields than longer maturities
US Treasury Yield Curve
Source: FactSet, January 15, 2024
Additionally, timing is becoming more of a factor due to reinvestment risk. The 3-month T-Bill is yielding 5.4% as of January 2024, but will its yield still be that high in 3 months? What about the 3 months after that? The chart below shows three hypothetical rate paths for the three-month Treasury yield, with the first one being a constant yield over the three-year period. If the expectation is that short rates will decline at some point soon, the realized yield over 3 years by rolling 3-month Treasuries (or remaining in other cash instruments) may be considerably lower than what is available now. On the other hand, a very well-known BBB+ rated media company with a maturity in November 2026 has a yield to maturity of 5.4%. At first glance it may be easy to dismiss this bond since its yield is equal to that of a risk-free T-Bill. However, when factoring in what the actual realized yield may be after three years, that corporate bond suddenly looks attractive. Similarly, an A- rated tax-exempt municipal bond issued by a transit authority of a major city has a yield to maturity of 3.7%. Using the highest federal tax bracket, this bond’s tax equivalent yield is 6.2% for the three year bond.
Potential 3-Month Treasury Yield Paths
Source: FactSet. As of January 15, 2024
1yield shown is the tax equivalent yield calculated using the highest federal tax bracket of 40.8%. Actual applicable tax rates, including state tax rates, may vary and could cause net after tax yields to be lower. Not to be construed as tax advice.
Finally, it is important to acknowledge that US Treasury yields have been particularly volatile this year. Since bond prices are inversely related to yield, increases in Treasury rates can drive bond prices lower. The below chart is a breakeven analysis which shows how much rates would have to increase to drive prices down so that the one-year return would be zero. Not only are longer-term rates similar to shorter term rates, but they have much lower breakevens meaning they aren’t as immune to rate increases as shorter duration bonds. The shorter duration bonds, both taxable and tax-exempt, have breakevens that are quite high due to their relatively high yields. For investors reluctant to step out of cash because of rate sensitivity concerns, shorter duration bonds may represent a more appropriate investment.
Higher Yields Mean Shorter Duration More Immune to Rate Moves
Source: FactSet. As of January 15, 2024
There is merit to the “T-Bill and chill” approach to fixed income as cash is generating income not seen in years. However, it may be prudent to deploy some of that cash into more traditional fixed income, particular due to the inherent reinvestment risk of cash products. Longer duration bonds can appreciate if yields fall, however they aren’t currently offering higher yields than short term bonds. Additionally, short duration bonds have high breakevens which make them more resilient to rising yields. Because short duration bonds are currently generating attractive levels of income with limited rate sensitivity, they may be an attractive solution for those looking to step out of cash.
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