Stepping out of cash: Why short-term municipal bonds are worth a look this tax season

For many investors, cash has felt like a comfortable place to wait. Elevated short-term rates have made money markets and cash vehicles more attractive than they were just a few years ago, particularly during periods of market uncertainty. But as tax season arrives – and volatility remains a constant feature of today’s markets – investors are increasingly revisiting an important question: is staying in cash still the most efficient choice?

Short-term municipal bonds (munis) are reentering the conversation. With tax-exempt income near the higher end of its post-financial crisis range, relatively low sensitivity to interest rate moves, and solid underlying credit fundamentals, we believe short-term munis present a compelling alternative for investors looking to move beyond cash while maintaining flexibility (Table 1).

Why tax season changes the conversation

Tax season has a way of sharpening focus. It turns pretax yields into after-tax realities and reminds investors that what ultimately matters are not what an investment earns, but what investors keep.

For those in higher tax brackets, the tax-exempt income generated by munis can materially improve outcomes. In today’s market, short-term municipal yields in the 3–4% range translate into meaningfully higher taxable equivalent yields for many investors (Chart 1).

When compared with taxable alternatives such as Treasuries or corporate bonds, the difference can be significant (Chart 2) – particularly once federal, state, and local taxes are taken into account.

This tax aware perspective is especially relevant during filing season, when investors are reassessing income sources and portfolio efficiency. Short-term munis offer a way to generate tax-exempt income without requiring a move into longer dated or more volatile areas of the bond market.

A more measured step beyond cash

Cash plays an important role in portfolios, offering liquidity and short‑term stability. But it also has limitations – most notably reinvestment risk, or the risk that today’s attractive yields may not be available tomorrow.

As interest rates eventually move lower, investors holding excess cash may find themselves reinvesting at less favorable levels, often without the ability to lock in income. Over time, taxes can further erode those returns.

Short‑term munis are increasingly viewed as a practical next step for cash that is not immediately needed. They offer the opportunity to capture tax‑efficient income today while maintaining relatively short maturities and portfolio flexibility. The tax exemption can provide meaningful tax savings vs. other taxable cash options (Table 2). For investors hesitant to extend duration or take on additional credit risk, short‑term munis can serve as a bridge between cash preservation and income generation.

Built to navigate volatility, not chase it

Market volatility has reinforced the importance of risk management. While longer‑dated bonds can offer higher yields in certain environments, they are also more sensitive to changes in interest rates. Short‑term munis, by contrast, typically carry lower duration and reduced-price volatility.

Historically, short‑maturity municipal strategies have experienced smaller drawdowns during periods of rate uncertainty and have tended to stabilize more quickly when markets adjust. This profile can be particularly valuable for investors who prioritize capital preservation alongside income – such as those approaching retirement or transitioning from saving to spending.

Rather than attempting to time rate moves or predict market turning points, short‑term munis manage volatility largely through their structure. Shorter maturities help limit interest rate exposure while allowing income to play a greater role in total return.

When income does the heavy lifting

One defining feature of today’s short-term municipal landscape is the role income plays in total return. With elevated starting yields, income has accounted for a substantial share of returns in recent years, helping offset periods of price fluctuation.

In practical terms, this means investors may be less reliant on favorable rate movements or price appreciation to meet their objectives. For those seeking steady, predictable cash flows – particularly in taxable accounts – this income-driven return profile can provide welcome clarity.

Strong credit foundations beneath the surface

Income is only as reliable as the credit supporting it, and municipal credit fundamentals remain sound. State and local governments are generally well capitalized, with reserve levels that have helped cushion budgets through economic uncertainty.

Across the municipal market, credit upgrades have continued to outpace downgrades (Table 3), and default rates remain historically low compared with corporate credit markets. These factors underpin the ability of short-term munis to deliver consistent income.

Supporting the transition from saving to spending

As investors move closer to retirement, priorities often evolve. While growth remains important, income stability and capital preservation typically become more central to portfolio construction.

Short-term munis have long played a role in taxable portfolios for this reason. Their combination of tax efficiency, predictable income, and historically low default rates align well with the needs of investors transitioning from accumulation to distribution. Rather than relying on asset sales during volatile periods, income-oriented strategies can help support spending needs more consistently.

Therefore, stepping out of cash is not about taking on more risk – it is about reallocating toward assets that can better support long-term financial goals.

Why short-term munis matter now

The case for short-term munis is not only structural; it is also timely. Elevated frontend yields, ongoing market uncertainty, and the annual reminder of tax obligations have converged to create a moment when after-tax income matters more than usual.

For investors sitting on excess cash, the opportunity cost of waiting is becoming clearer. While no single allocation fits every situation, we believe short-term munis offer a way to balance income, risk management, and tax efficiency at a time when those considerations are top of mind.

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).

AA-070426-206411-1