The fixed income market is in transition as we are on the eve of the Federal Open Market Committee’s (FOMC) September meeting where it is anticipated, no – it is expected, that the FOMC will reduce rates for the first time since 2020. As investors, it is important to understand what rate the Fed controls, what it means to the fixed income market and where we see opportunities.
The Fed’s job is to control monetary policy for the United States. They have several tools to help them in this enormous task, one being the setting of the Fed Fund rate, which is simply the rate that banks pay to borrow overnight from one another in order to meet their reserve requirements and maintain liquidity. This simple tool is quite powerful and is utilized to help stabilize the overall economy especially during periods of inflation and recession.
Although the Fed Fund’s rate is established for these short-term interbank loans, it has a significant impact on our economy, affecting a wide range of lending. Rates of return for CDs, treasuries, agency securities, and municipals are all affected by the Fed Fund rate. What we as consumers pay for borrowing is also affected, from personal loans, credit card rates, and auto loans to long-term loans such as home mortgages. If there is a rate associated with lending or borrowing, the Fed Funds rate affects it to some degree.
For many years after the financial crisis of 2008-2009, rates were extremely low, artificially low in the opinion of many economists. Then, following the COVID epidemic or 2020, we entered an inflationary period coupled with low unemployment. Rapid inflation is something the Fed attempts to mitigate, so a series of rapid Fed Funds Rate increases, eleven in total, were declared by the Fed from spring 2022 to summer 2023. These rate increases were meant to put the breaks on a heated economy, and they have done the trick. The Fed walks a fine line in increasing the Fed Funds Rate without putting the economy in a tailspin and causing a recession. So far, while the increase in rates has been somewhat painful, it appears the Fed has done a masterful job, and although the economy is softening, we just may be in for a soft landing if we can avoid a recession.
Beginning in 2022, investors were awakened to the opportunities in fixed income securities presented by rising interest rates with relatively low risk. Yields over 5% were seen even for Treasuries, the highest quality fixed income offerings. Investors began to lock in rates, especially short-term securities, and flocked to higher yielding money market funds. Even as rates have begun to settle and yields retreat, balances in money market funds remain historically high. We think that having a large allocation in a money market fund for its yield is potentially not wise. Yes, it has been a bit of a party for short-term fixed income investors, but as they say, it is best not to stay at the party too long. Rates are easing, and the Fed is likely to make rates retreat even more quickly. When appropriate, it is time to lock in rates if you haven’t already done so.
As we write, yields are still very attractive across the spectrum of fixed income securities even though the yield curve remains inverted, with shorter term rates higher than longer term. An inverted yield curve has historically signaled a recession, but as we walk this fine line with the Fed and look to a soft landing in what appears to be a relatively strong economy, we see opportunity. If this soft landing comes to pass, and the economy expands, as the Fed lowers rates, we believe the yield curve will return to its normal stance where short term fixed income securities have a lower rate than long term fixed income securities.
In addition to being in a rate transition as the Fed eases its quantitative stance, we are also on the brink of an election, which, depending upon its results and the makeup of all branches of the government, could significantly impact our personal and business tax rates. We won’t know what that looks like until after the November 2024 election and see which party has control of congress and the White House. One thing we do know is that things are about to change as the 2017 tax cuts put in place during the Trump administration are set to sunset at the end of 2025. Tax changes are on the horizon.
As wealth managers, we are constantly looking for opportunities. With decreasing interest rates and potentially higher income tax rates, we believe this could be a fortuitus series of events for the municipal market. Munis, whose income is traditionally exempt from Federal income taxes, and in some cases exempt from state income taxes, have had a strong year in 2024. Yet, even with rates easing in the municipal market, we are experiencing very attractive rates of return. For example, the S&P Municipal Bond 5+ Year Investment Grade Index has shown a +7.99% total return for 2024 (through 9/12/24) and investment grade five year Munis, which are being offered at approximately 3.8% yield to maturity, have a tax equivalent yield of 5.85% (35% tax bracket). If income tax rates increase in upcoming years, which seems likely this tax equivalent yield can be even more attractive. Finally, municipal securities offer investors a way to invest in communities, sometimes even their own communities. There is a certain satisfaction in knowing you have lent money to help a municipality.
Municipal bonds do not get the attention that other fixed income securities enjoy. But as they sit quietly in the background, we think they are a great additional tool to add to your belt. They are uniquely poised to offer attractive yields, increased total returns as rates decline, and increasing tax equivalent yields if we enter a period of higher tax rates. It is not the rate we earn on an investment that is most important, it is what we keep in our pockets after taxes that counts – and Munis offer this opportunity.
Security availability and yields are subject to change. Past performance is not a guarantee of future results.