Rethinking Cash: Is it Time to Seek Higher Yield Elsewhere?

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Stacie Jacobsen: Thanks for joining us on The Pulse by Bernstein, where we bring you insights on the economy, global markets, and all the complexities of wealth management. I’m your host, Stacie Jacobsen.

We’re starting today’s episode with a question for our listeners, and that is, how much interest are you actually earning on cash? If you said something like five percent or even four percent, you might be unpleasantly surprised by what you actually keep. As a recent blog post on the podcast, Some accounts advertised as offering four percent are often paying far less.

Joining us today is the author of that blog post, Todd Buechs, Bernstein’s National Director of Core Fixed Income and Alternative Credit. Todd will explain what’s been happening with cash, and he’ll share his best ideas on how to get that money working for you. Todd, welcome back to The Pulse.

Todd Buechs: Thanks, Stacie.

It’s good to be back.

Stacie Jacobsen: Let’s start with cash. In the past few years, it’s gone from a very attractive option to a less attractive one, and now it’s likely to be on a continued descent. Can you talk us through that trajectory?

Todd Buechs: Most money market funds synonymous with cash are going to return something in alignment with Fed funds.

We know that Fed funds was near zero coming out of the pandemic. And that the Fed kept rates artificially low for quite some time. And they’ve got that dual mandate of full employment and then maintaining purchasing power. There was really no inflation and they wanted to make sure that the economy recovered.

So, they kept rates low for probably too long and then started raising in 2022. At the time they started raising money, market funds were paying 0.01percent. Because rates were at zero, you couldn’t make much and as they raised rates up to five and a quarter to five, five percent, money market funds moved with that. So, you went from a place where you got really no return, but safety of principle to a place where you got returned that rivaled what you would get from bonds.

And at sometimes, especially kind of really short government paper was better than bonds. That was a great place to be. It was a great place to be when rates are going up and that hurt bonds. But now that the Fed is on a path of easing, we expect money market funds to move down lockstep with Fed funds rates.

They’ve already moved down there at about four and a half percent when they were yielding five pre the cut in September. And we expect that it’s going to get down to maybe high twos, 2.75 to 3 by the end of 2025. So, it’s not going to be as attractive an asset class going forward.

Stacie Jacobsen: All right. Now many investors have that five percent rate that you mentioned kind of locked in, right?

So, on money market funds and the cash like instruments, but when you think about it, it caused money to flow out of the more traditional asset classes and into cash. But were people really getting five percent?

Todd Buechs: It depends. One of my favorite words, if you’re in a tax-exempt security, a municipality, then you’ve got some tax advantages.

You’ve got tax free income, but most people really just liked five. Treasuries were paying five, CDs were paying five, savings accounts were paying five. Most of the conversations I had with people, they just liked the five and they would worry about taxes later. If you think about a top marginal taxpayer, call it 40, almost 41 percent taxes.

If you’re making five and you’re paying top marginal and the income is taxable at the Federal level, you’re talking about really making three.

Stacie Jacobsen: Yeah.

Todd Buechs: And if you’re in a high tax state, you’re talking about making even less. So, the five was a nice rate to have at a top line, but we think bottom line and after tax, and you’re probably talking kind of two and a half to three four.

Investments that were taxable, both the state and federal level.

Stacie Jacobsen: In addition to the rate reductions, you have highlighted another issue that’s going on with cash within the industry. And that was highlighted in your blog as well. And that’s the treatment of what’s called the sweep accounts. Can you just talk us through what’s going on there?

Todd Buechs: So, sweep accounts are when a bank will sweep frictional cash. So, if you have a bond that matures and it’s waiting to be invested in order to get some additional return and not just pay a management fee on that, they can sweep that cash over to another account. Now, in the beginning of that program, I think it was to give you more return on those monies.

And actually, it’s all really started with checking accounts, which they couldn’t pay additional returns on probably 20 years ago. But when you sweep it over, you’re supposed to get a better return benefit you, unfortunately, or fortunately for banks, banks are in the business of making money and many banks when rates were really low, paid a very low rate.

We’re talking less than a half percent on that frictional cash. Now, when you’re getting one basis point in the money market fund, that looks pretty good. But what happened when rates ran up to five and a quarter to five fifty un Fed funds, Many banks left the rate at 0.25, 0.35, 0.45 percent and didn’t change it.

And now they’re all being named in lawsuits, et cetera, because customers saw that they weren’t benefiting from higher rates. What do banks do with those monies? They lend them out. I looked at a client account, potential client, and I looked at what they were paying on their margin, seven and a half percent to borrow and what they were making on their cash, 0.45 percent. Essentially what they were doing is they were getting paid 0.45 percent on the money they had at the bank, which was then lending their own money back to them at seven and a half percent. That’s a huge driver of profitability for a bank and it’s why it’s drawn a lot of scrutiny. Okay.

Stacie Jacobsen: Okay. Thanks for bringing that to our attention here today.

And then again, in the blog. So, Todd, you highlighted the difference between that headline number of five percent and then walked us through what taxes take out of that to what the bottom line number would be the amount that you keep. So, for investors who had previously focused on the headline number and are now wanting to focus on that.

Bottom line, what you keep number, what are some options that are still relatively safe for investors to move off of cash?

Todd Buechs: Well, in my role, you know, fixed income is kind of my life. When I walk people through why they should be in bonds and maybe just take a step back and say what happened to bonds as rates were rising in 2022 and 2023, we saw outflows from high credit quality municipal bonds.

About $130 billion float out in ‘22 and ‘23 year-to-date, about 30 billion have flown back in. So, there’s a big delta between what was there in portfolios and what there is now, and there’s about six and a half trillion dollars sitting in money market funds, which could be three to three and a half trillion more than normal.

So, the conversations I’m having about what’s more attractive. Well, we think about returns on an after-tax basis. I think investors should. It’s the easiest way to save on taxes is to avoid them. Municipal bonds, if you’re, they’re in state, they’re double tax free. That’s an easy way. And yields are higher than they’ve been in 15 years.

That’s taxable bonds or municipal bonds.

Stacie Jacobsen: Why are yields higher than they’ve been in the last 15 years on Muni bonds now?

Todd Buechs: So much like treasuries, treasuries reflect it’s an auction and the only rate that the Fed sets is Fed funds. And when they raised rates, you know, it’s because they were trying to stem inflation.

The rest of the yield curve moved with that. You have to get some return. If I want someone to buy a 10-year treasury, if it’s paying less than cash, people won’t buy it. So, at auctions, the yield start going up to attract more buyers. So rates started to move up and municipal bonds, although they won’t move in lockstep with treasuries, they move about 60 percent of the way.

Yields have gotten higher. Why people get out of bonds when you sell a bond, the price goes down, the yield goes up. So, after coming out of a period of extremely low interest rates, when people started selling those bonds ahead of perceived Fed action, which wound up being a lot, most we’d ever done in history, yields went up and prices went down, and now we’re at a point where yields are higher than they’ve been in 15 years.

I’ve got a Fed that is set on a path of easing, which means lower rates, I should get price appreciation and then, oh, by the way, there’s a lot of money, trillions of dollars sitting in money market funds that you’re going to wake up tomorrow and realize I’m not getting five anymore. Now it’s four and I could be getting down to three when I can get a much higher tax equivalent yield.

Stacie Jacobsen: For many who do have liquidity needs, there’s a priority on maintaining flexibility, especially in the cash or fixed income portion of the portfolio. So when you think about structuring bond portfolios, how do you think about adding more duration with munis?

Todd Buechs: When I’m talking to a client, I want to know about their liquidity needs, as you said.

Stacie Jacobsen: Yeah.

Todd Buechs: If I’m talking to someone who’s got near term expenses, a wedding, a home purchase, taxes due. That’s a cash something. Why? Because we know we don’t have enough time for that portfolio to grow. So, the rates move dramatically against the client that have a drop in value. When I start thinking about the monies, you know, I want to bucket it.

What’s your two- and three-year goals or spending or whatever that is. If we’re talking about a long-term mass allocation and a globally diversified portfolio, it’s going to be intermediate. Kind of interest rate risk. So, think of bonds kind of in the five to twelve year maturity, because that’s a long term mass allocation.

If rates move, you’ve got plenty of time for that portfolio to heal. I always say time heals, spawn wounds where you’re earning back income and it fills in whatever drop in value. The nice part about right now is that because yields are higher, if we did have higher rates, you have plenty of yield to offset that as opposed to back at the beginning of 2022, when yields were so low, you couldn’t bid up the price anymore and have that offset to market volatility.

So thinking about adding duration, I want to match and have longer maturities, more interest rate sensitivity for the longer time horizon. So, these are conversations that have been going on for a year or more, because as we started off, we talked about five percent and the attractiveness of that.

But now that clients realize that that five will become four and a half or it’s become four and a half will be four by end of year. And most likely. 2.75 to three at the end of next year. And they start looking around for more return. We’ve been talking to those clients about bonds for a long time and they all felt, well, I’m still getting five, so, I’m okay. I’ll figure it out later.

Well, later is now, and with the almost certainty that the Fed’s going to ease as much as they are, I mean, everything they’ve said they’re going to do, they’ve done, I would expect that means we’re going to be at 2.75 to three. There’s a good time to move into what was, could have been your long-term asset allocation.

Cash is not a long term asset allocation. It’s longer duration or longer maturity municipal bonds for taxable investors.

Stacie Jacobsen: I’m thinking specifically about investors who have a liquidity event, right? So often that’s tied with an M&A and transaction, a business owner that’s selling and look, I don’t blame them, but there’s not typically an immediate focus on redeploying the proceeds from the business.

So, what would you say to that cohort of investors that might leave cash a little bit longer and they should really be getting their money working for them sooner?

Todd Buechs: As a matter of fact, I’ve had multiple conversations over just the last couple of days with business owners who had sold. And these are large sales and I think it was some complacency, kind of an exhale after the deal is done.

Stacie Jacobsen: And who can blame them though, right? So, yeah.

Todd Buechs: Oh, I completely understand. They’ve gone through all of the meetings, et cetera, for valuation of companies, signing contracts, and finally getting it done. And the next thing on their mind is not to then go and sit down and do an asset allocation. But as rates are starting to fall, one of the things we’ve done to talk to clients is about, let’s move and get a little bit more duration or interest rate sensitivity of portfolio.

So, we can earn a little bit more and protect you because you’re going to wake up and you’re going to making half of what you’re making right now on your cash. And then we have figure in their taxes. It’s even, you know, it’s a small amount. You’re not going to be earning a whole lot.

So we’ve kind of dipped our toe in that’s not our long term advice, but if you’ve owned a business and not had an investment portfolio for a long period of time, you start to get to see what does a portfolio do, Even if it’s less risky, less interest rate sensitivity, you know, to kind of move them out of where they are.

I’m talking to a business owner right now, who’s been sitting on cash for three years, you know, from a, from a business sale. And, you know, well now he finally realizes that I’m not going to be able to count on the five. And now we’re talking about really building out an asset allocation, including some stocks, because I don’t think he’s ready to be full bore on stocks.

A lot of bonds and some alternatives that provide some more diversification to a portfolio.

Stacie Jacobsen: All right. So, you talked about extending duration, but when we think about the risk spectrum with Munis, right? Very different than the equity portion of the allocation, but there still are different levels of risk inside of a Muni portfolio.

So how do you typically think about high quality Munis and the rate associated with that versus moving up the risk spectrum?

Todd Buechs: First, let’s just compare Munis to taxable bonds. If I look at 10 year rolling periods of defaults for all investment grade municipal bonds, that’s triple a double a single a triple B.

It’s less than 0.2 percent. That’s not a lot. Now, any legal disclaimer would say, you can’t say that you’re not going to lose money because you could lose money. There’s always risks in the markets. But if you’re researching a portfolio and the default rate on investment grade municipal bonds is 0.2 percent over 10 year rolling periods, that sounds pretty safe to me.

And taxable bonds have much higher default rates. And if you think about it, a municipality has one source of funds. The source of funds would be the bond market. If I’m running a municipality, a water district, I can’t sell the pipes from main street to maple street. That’s part of the municipality. I can’t raise rates unless I go through a process where the rate raises are approved.

So, if I need to replace lead pipes with, you know, with better pipes, whatever it is, I have to jealously guard my ability to raise funds. Therefore, municipalities make sure they have lots of rainy day funds. They have the ability to service that debt. And as a good researcher, you want to look at that and make sure they can.

So, a corporation can do a lot of things, raise money a lot of ways. It’s just a very different situation than if you have your back against the wall, like a municipality.

Stacie Jacobsen: Okay. So, we’ve talked about the benefits and risks of individual Munis, right? On the tax duration and the credit risk spectrum. For investors who actually do want to build out a municipal bond portfolio for diversification, what should they be thinking through like risks, benefits to the overall portfolio?

Todd Buechs: Sure. So, when I think about a bond portfolio, it should do three things in that diversified and balanced account. And I’m just going to talk stocks and bonds. Stocks should deliver the majority of the return over time, but also over 90 percent of the risks, the volatility in a portfolio. Okay. Bonds are there to protect principle.

That’s means it’s investment grade portfolio. We’re not trying to buy bonds or you shouldn’t be trying to buy bonds that you might lose money in, they should provide income. And right now, as I said, better yield than you’ve gotten in 15 years, but they’re also there to diversify the portfolio. And what does that mean?

That means that if I’m in equities and the market drops precipitously, 20 percent drop, I’ve got a couple of choices. I can ride it out. I could add money, but if I don’t have money, what do I do? I could sell my equities, which many people do. If I sell my equities, what can I invest in? I can invest in cash.

Which will not appreciate, but will protect, or I could buy bonds. If I buy bonds, I drive the price up and the yield down. So, in a portfolio of stocks and bonds, if the market falls and others panic and sell, then they buy bonds, your portfolio moves up in value. It’ll never be one for one. Equities are more volatile, they’ll move more.

But, you know what, if you needed some money, Stacie, from the portfolio, We could sell a little bit of appreciated bonds and lock in losses and let the portfolio heal over time. So, you know, that diversifier allows someone to have more equities in their portfolio than they maybe would have otherwise.

Stacie Jacobsen: Okay, that’s helpful.

You know, I think for some it’s counterintuitive to go into a fixed income instrument when we’re in a interest rate environment that is reducing, right? So why is it that now is a good time to invest in Munis?

Todd Buechs: Sure. Well, you know, highest yield we’ve gotten in 15 years, number one. So, you start off with a higher yield.

If I buy that bond and rates fall, let’s just say I have a 10 year bond that is yielding 5 percent to make the math easy. If rates fall because the Fed starts cutting and all other bonds at that maturity are yielding four in say six months and mine’s still yielding five. Cause I bought it at five. I have appreciation in my portfolio.

The cash piece was if I held the cash, I’ll make some yield, but then As the Fed cuts rates, my rate drops, but I don’t get price appreciation. So, it’s a point in time where you can have price appreciation. When rates fall, you start with a higher yield. And there’s a lot of cash on the sidelines that could move in and bid up prices.

And then finally, when we think about the Muni market, we think about supply and demand. September and October this year, there was a lot of supply. So, more bonds were issued than matured. In November and December. It’s going to be negative net supply months. So that creates a supply demand mismatch. You’ll have a lot of people trying to invest and you’ll have very few bonds to invest in.

We think it’s a really good time to invest.

Stacie Jacobsen: Todd, I want to ask you a little bit more about the net supply concept. Can you break it down and explain it to us?

Todd Buechs: Sure. Well, corporate bonds, there’s say 45,000 different bonds. Muni market, there’s over a million and it’s really, you know, it’s a fragmented market in that it’s dominated by retail investors buying one or two bonds.

That’s over 50 percent of the market. So fragmented market, a lot of different bonds that you could research and look at in the summer months, there’s very little issuance. So, kind of rule of thumb, you might want to think about buying when there’s little supply. And what I mean by net supply is if I take all the bonds that are issued in a month.

And I subtract from that, all the bonds that mature in a month, if it’s positive, I need more buyers to support prices. And if it’s negative, very little buying can drive the prices up. And as I alluded to September and October, there was a lot of net issuance; more bonds were issued than matured. And in November and December, it’s decidedly negative over 20 billion negative net supply.

When I have that, those monies potentially flowing out of money market funds in the trillions of dollars. It’s going to find a home. There was a bond being issued by Memphis, Tennessee for student housing. Now, Memphis, Tennessee, you know, it’s not a big issuer of debt, but it is a large municipality. It was a 76 million bond offering.

So that’s all they were looking to raise as a kind of a barometer of the amount of demand out there. It was 30 times oversubscribed. Three times oversubscribed is 2.3 billion worth of demand. You know, I, I just look at the numbers and how much money is not moved back into the market compared to what moved out.

And I just think from a supply demand perspective, investors could benefit if they’re in the municipal market over the next 12 to 24 months.

Stacie Jacobsen: Yeah, that certainly does highlight the environment that we’re in today. All right, Todd, do you have any final thoughts you’d like to leave our listeners with today?

Todd Buechs: Sure. So, what I talked to a lot of clients about is I say, look, cash was a great decision through October 31st of 2023. Once the Fed said, hey, we’re done raising, it was kind of off to the races for bond portfolios and equities. I would say now is the time to really reexamine your asset allocation because cash won’t be a great decision.

As a matter of fact, since October 31^st of 2023, even a, a portfolio of just 30 percent equities and 70 percent bonds has massively outperformed the cash allocates. It’s not the safe haven anymore. You’re not going to get the price appreciation and you’re going to see your yield drop. I’d rather swap into something that’s going to give me a chance for upside and higher yields.

Stacie Jacobsen: Okay, Todd. Thank you so much for joining us today and we will be sure to link that blog post in the show notes.

Todd Buechs: Love it. Thanks.

Stacie Jacobsen: Thanks to everyone for listening. Please join us again in three weeks for our next episode. I’m your host, Stacie Jacobsen. Wish you a great rest of the week.