The Federal Reserve is anticipated to begin reducing interest rates on Wednesday afternoon, signaling a potential shift away from high-yielding money market funds. Since March 2022, the central bank has steadily increased rates, consequently raising yields on various basic investments such as Treasury bills and certificates of deposit. Presently, the Fed’s benchmark interest rate is in the 5.25% to 5.5% range. However, the substantial 5% yields on money market funds are predicted to decrease substantially as the Fed starts to lower historically high rates. The 2-year Treasury yield, which is particularly responsive to Fed policy, has already dropped significantly to 3.59%, down from its peak of over 5% in April.
Kathy Jones, the chief fixed income strategist at the Schwab Center for Financial Research, noted the difficulty in convincing investors to extend the duration of their investments when short-term options like T-bills or money markets offer 5% yields. Duration refers to a bond’s sensitivity to interest rate changes, where bond yields move inversely to their prices, and longer maturities typically indicate higher duration.
Tony Miano, an investment strategy analyst at Wells Fargo Investment Institute, recommended intermediate-term investments, which typically have durations of five to seven years. This segment offers attractive yields without excessive exposure to price volatility. Miano’s team forecasts a one percentage point cut in the Fed’s benchmark rates in 2024 and an additional three-quarters of a point the following year, and he suggests that high-yield taxable fixed income could be a worthwhile option for investors’ surplus cash.
For those seeking to transition out of cash, diversification is crucial. Jones pointed to investment-grade bonds and tax-free municipal bonds as viable options. Municipal bonds, which are free from federal taxes and state levies if the investor resides in the issuing state, can be particularly beneficial for high-income investors despite their lower yields compared to corporate bonds and Treasurys. According to New York Life Investments, a taxable bond would need to yield 4.41% to equate to a 3% tax-free yield for an investor in the 32% tax bracket.
In the corporate bond sector, high-quality investment-grade bonds are yielding around 4.5% to 5%, offering potential returns over a five- to seven-year period, according to Jones. For additional diversification, Gene Goldman, chief investment officer at Cetera Investment Management, recommends mortgage-backed securities. Although prepayment risks exist, particularly as homeowners look to refinance in a declining interest rate environment, Goldman believes this concern is already factored into current prices. The 10-year Treasury yield, which influences mortgage rates, had peaked over 5% last October but is now trading around 3.65%.
Investors seeking a simpler method to diversify their fixed income portfolio might consider core bond exchange-traded funds (ETFs), which often include a mix of government bonds, corporate bonds, and securitized debt like mortgage-backed securities.
When reallocating cash into fixed income, it is important to consider the investment time horizon and liquidity needs. Financial planners typically advise maintaining 12 months of liquid cash for emergencies. For clients aiming to earn some interest on funds needed within the next three to five years, James Shagawat, a certified financial planner at AdvicePeriod, suggests using short-term bond ladders. This strategy involves buying bonds with staggered maturities and reinvesting proceeds as they mature. By laddering in a falling rate environment, investors can benefit from initially higher yields while mitigating the impact of reinvesting at lower rates over time. Shagawat favors laddering for offering more stable income through mixed-term investments.
