Fed Rate Cuts: What to Expect
In July, the Federal Reserve hinted at a potential rate cut during their upcoming September 17-18 session. This speculation gained traction on August 21, when the Labor Department revealed that the U.S. economy had created 818,000 fewer jobs in March than initially reported—the largest revision since 2008. Additionally, the Fed’s preferred inflation measure has dropped from a peak of 7.1% in 2022 to just 2.5%, trending towards the 2% target. These factors support the likelihood of a rate cut in the near term. The pressing question now is not if the Fed will cut rates in September, but by how much.
Understanding Muni Bond Tax Equivalent Yield
Municipal bonds (munis) are often exempt from federal income tax, and sometimes state and local taxes, making them an attractive investment. To compare the returns of these tax-exempt bonds to taxable bonds like corporate or Treasury bonds, investors use the tax equivalent yield. This calculation accounts for the tax savings, providing a fair comparison. For example, if a muni bond yields 4% and your marginal tax rate is 25%, the tax equivalent yield would be 5.33%. This means a taxable bond would need to yield 5.33% to match the after-tax return of the 4% muni bond.
The Barbell Bond Strategy
A barbell bond strategy involves dividing a bond portfolio into short-term and long-term bonds. This approach combines the stability of short-term bonds with the potential for higher yields and price gains from long-term bonds, creating a diversified and resilient fixed-income portfolio. Currently, the intermediate-term portion of the yield curve offers the lowest tax-equivalent yield, making a barbell strategy more appealing for higher yields and stability.