Considering Moving Out of T-bills? A Guide to Determine What’s Next in Your Portfolio
We outline four questions investors can ask themselves about their cash allocation as Fed rate cuts may reduce Treasury bill yields.
- Portfolio Construction
- Fixed Income Insights
- Cash Management
Key Points
What it is
What should fixed income investors consider when moving out the curve?
Why it matters
Investors piled into Treasury bills to capture relatively safe and high yields. As yields potentially fall, investors likely will reverse that trend.
Where it's going
Investors should consider their liquidity needs, income preferences, tax rate and the role of fixed income in their portfolios.
Since mid-2022, when the Federal Reserve was in the midst of its aggressive hiking cycle, investors piled over $1.6 trillion into money market funds, which include (T-bills) and other short term instruments1 with more than $6.22 trillion in money market funds as of August 15, 2024.2
The combination of competitive yields and low risk — because T-bills are issued by the U.S. government — attracted investors. Since late 2022, the relative yield offered by T-bills and money market instruments has been attractive versus longer maturity Treasurys because of the inverted yield curve, where short-term yields were higher than long-term yields.
As a result, T-bills and other money market instruments have been more attractive to investors than longer dated Treasurys, which are more sensitive to interest rate movements. A feature magnified in recent years as bond returns broke historical inverse relationships with equities as inflation surprises resulted in both equities and bond prices moving in the same direction — undermining diversification benefits of longer dated fixed income instruments.
Today, this trend is likely to reverse as the Federal Reserve embarks on a likely rate cutting cycle which will impact T-bill rates, and potentially out the fixed income curve. In doing so, the big questions are when to start moving, and where to go next.
Ultra-Short Strategies: A Historical Guide
If history is a guide, investors can potentially benefit by moving incrementally to longer dated bonds, such as ultra-short strategies, when the Fed starts its rate cuts. Ultra-short extends of bonds to up to three years and incorporates a broader opportunity set beyond Treasurys, including high quality corporate bonds and asset backed securities.
Exhibit 1 shows the historical movement of assets into ultra-short strategies during the last two prolonged rate-cutting cycles. In both cases, it was not until after the Fed started cutting rates that investors moved decisively into ultra-short strategies. As investors demand moves further out the curve, the subsequent purchasing has a dampening impact on yields, and later entrants can potentially end up with lower yields while riding T-bill rates down.
A Treasury bill is a loan to the U.S. government that matures in three, six or 12 months.
Duration measures the sensitivity of a security or portfolio to changes in interest rates. It often is used as a measure of risk to interest rate moves for fixed income securities and funds.
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
Main Point
Readying for a Rate Cut Cycle
As the Fed potentially enters a rate-cutting cycle, investors may need to ask themselves a few questions about their cash allocation as Treasury bill yields may fall.
Contact Us
Interested in learning more about our expertise and how we can help?
IMPORTANT INFORMATION
Northern Trust Asset Management (NTAM) is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Northern Trust Asset Management Australia Pty Ltd, and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.
Issued in the United Kingdom by Northern Trust Global Investments Limited, issued in the European Economic Association (“EEA”) by Northern Trust Fund Managers (Ireland) Limited, issued in Australia by Northern Trust Asset Management (Australia) Limited (ACN 648 476 019) which holds an Australian Financial Services Licence (License Number: 529895) and is regulated by the Australian Securities and Investments Commission (ASIC), and issued in Hong Kong by The Northern Trust Company of Hong Kong Limited which is regulated by the Hong Kong Securities and Futures Commission.
For Asia-Pacific (APAC) and Europe, Middle East and Africa (EMEA) markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. This document may not be edited, altered, revised, paraphrased, or otherwise modified without the prior written permission of NTAM. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. NTAM may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, its accuracy and completeness are not guaranteed, and is subject to change. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor.
This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions.
All securities investing and trading activities risk the loss of capital. Each portfolio is subject to substantial risks including market risks, strategy risks, advisor risk, and risks with respect to its investment in other structures. There can be no assurance that any portfolio investment objectives will be achieved, or that any investment will achieve profits or avoid incurring substantial losses. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Risk controls and models do not promise any level of performance or guarantee against loss of principal. Any discussion of risk management is intended to describe NTAM’s efforts to monitor and manage risk but does not imply low risk.
Past performance is not a guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by NTAM. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Net performance returns are reduced by investment management fees and other expenses relating to the management of the account. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise. For U.S. NTI prospects or clients, please refer to Part 2a of the Form ADV or consult an NTI representative for additional information on fees.
Forward-looking statements and assumptions are NTAM’s current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information.
Not FDIC insured | May lose value | No bank guarantee