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Point of View · 09.12.24

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
Format
Article
Executive Summary

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.

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.

Ultra-short fund flows during fed rate cut cycles

Sources: Morningstar for monthly fund flow data of U.S. ultra short category, Bloomberg for federal funds effective rate.

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.

Ultra-Short performance during various cycles

Sources: Northern Trust, Bloomberg, from 2007 to 2023 annually. The returns are after-fee composite returns for the Conservative Ultra-Short Bond Strategy and the Ultra-Short Bond Strategy. The BofA ML 91-Day T-Bill Index is an unmanaged index used as a general measure for money market or cash instruments.

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.

Sample taxable equivalent yield: California

Source: Northern Trust. For illustration purposes only.

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.

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