While it is tempting to wait for confirmation of policy changes, history and market dynamics suggest that the optimal time to act is before the first rate cut, not after.
For municipal bond (muni) investors, we believe this moment presents a rare opportunity to lock in attractive yields, add incremental duration, and position portfolios for long-term tax-efficient income.1
The current landscape: Signals & shifts
Despite a hawkish tone from the Fed during its July meeting, recent economic data, including weak payroll numbers and downward revisions to previous months, have boosted market expectations for a rate cut.
Futures markets are currently pricing in a high likelihood of a 25-basis point cut in September, even as Chair Jerome Powell remains cautious. August’s hotter-than-expected Producer Price Index could reinforce that caution.2 Still, with three Fed meetings left this year, there is plenty of room for a shift toward a more accommodative stance.
Meanwhile, money market balances have surged to an all-time high of about $7 trillion (Chart 1).
Chart 1. Money market growth (2020–Present)
Moving cash off the sidelines
The opportunity cost of holding cash is becoming increasingly apparent. If investors wait until the first rate cut to deploy capital, they may find themselves reinvesting at 50 to 75 bps lower yields. Simply put, on a $10 million investment, that would mean $50,000 to $75,000 per year in foregone tax-free income.
Munis offer a strategic alternative to cash, especially for investors in higher tax brackets. Their tax-advantaged income may deliver superior after-tax returns compared to money market funds, which may see their yields decline rapidly once rate cuts begin. Additionally, munis can complement taxable fixed income allocations while reducing overall portfolio tax drag.
Liquidity considerations
While munis are not as liquid as money markets, many exchange-traded funds and separately managed accounts provide efficient access to the asset class with diversified risk profiles.
Go long?
For investors concerned about duration risk, a barbell approach of mixing short- and longer-dated municipals can be prudent. This strategy allows investors to capture elevated income prospects while mitigating exposure to the ultra-long end of the curve as fiscal deficits put pressure on 20–30-year bonds. Conversely, the intermediate portion of the curve (3–5 years) remains inverted and does not currently compensate investors for extending duration.
“For timing is in all things the most important factor”
Markets often move ahead of the Fed. Historical patterns show that by the time the central bank begins cutting rates, yields have already adjusted downward. Acting early allows investors to capture the most favorable entry points and avoid the herd mentality that can drive prices higher and yields lower.
Behavioral finance also plays a role. Investor inertia, or the tendency to wait for confirmation or consensus, can lead to missed opportunities. We believe that by proactively repositioning portfolios now, investors can sidestep the reinvestment trap and secure long-term income at today’s elevated yield levels.
Final thoughts
With the Fed signaling a potential shift toward rate cuts, we believe the urgency to act has never been greater. Investors who wait for confirmation risk missing the most favorable entry points, as markets often adjust ahead of policy changes. By proactively positioning portfolios now, muni investors can capture elevated yields, benefit from roll-down on the curve, and avoid the reinvestment trap that comes with declining rates. Munis are an asset class that offer a rare combination of tax-efficient income, defensive sector exposure, and rate sensitivity – making them an ideal vehicle for adding incremental duration in today’s environment. To manage both duration and reinvestment risk effectively, we believe investors should consider a barbell approach to investing in muncipals. This strategy allows for balancing income generation and capital appreciation prospects with flexibility as market conditions evolve. The window of opportunity is open; however, it may not stay that way for long. Acting ahead of rate cuts can help investors lock in attractive yields and position their portfolios for long-term success.
Endnotes
1 A measure of the maturity of a bond or portfolio of bonds that takes into account the periodic coupon payments. It attempts to measure market risk, or volatility, in a bond by considering maturity and the time pattern of interest payments prior to repayment. Two bonds with the same term to maturity but different coupon rates will respond differently to changes in interest rates. So will bonds with the same coupon rate but different terms to maturity. The higher the duration, the greater a bond’s price-sensitivity to changes in yield.
2 The Producer Price Index (PPI) program measures the average change over time in the selling prices received by domestic producers for their output.
Important information
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
The tax implications of tax management techniques, including those aimed at harvesting tax losses, are complex and uncertain, and they may be subject to challenge by the IRS. Please note the following: (i) any discussion of U.S. tax matters contained in this communication cannot be used to avoid tax, penalties, or interest imposed by the IRS or any other taxing authority; (ii) this communication has been written to support the promotion or marketing of the subjects discussed herein; and (iii) you should seek advice tailored to your specific circumstances from an independent tax advisor. Neither Aberdeen nor its affiliates provide tax advice.
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