The Federal Reserve may get around to raising its short-term interest rate target later this year, but short-term bond yields already reflect that eventuality. Investors and savers can boost their yields without adding much risk by shifting out of money-market funds.
But to what, exactly? Extending to longer-term securities adds significant risks without commensurate returns. And the prospect of Fed rate hikes also increases the potential downside for leveraged investments, such as many closed-end funds. Still, there are some bargains to be had -- namely among shorter-term Treasuries. And a few closed-end funds still make the cut.
Fixed-income markets rendered a split decision following Wednesday's Federal Open Market Committee meeting, at which the policy-setting panel held its federal-funds target range at 3.50% to 3.75%, albeit with three members dissenting in favor of a quarter-percentage point hike. While that wasn't unexpected, the contrast between Fed Chairman Kevin Warsh's staunch anti-inflation rhetoric and the lack of specifics to bring inflation down produced a sharp selloff in long-term bonds. That lifted the 30-year Treasury yield to a 19-year high of 5.24%, in what was seen as a vote of no-confidence for the new Fed chief.
At the same time, the two-year Treasury yield plunged from 4.34% before the FOMC decision Wednesday afternoon to 4.24%, as the bond market pared back its expectations of future Fed rate hikes. By Thursday, fed-funds futures put about a 60% chance of a quarter-point hike at the next FOMC meeting, ending Sept. 16, according to CME FedWatch. The likelihood of an increase to a range of 3.75% to 4% rose to over 70% by October and over 80% by December. A further rise to a range of 4% to 4.25% isn't seen until early next year.
Given the futures market's forecast -- which is probably the best guide, given Warsh has eschewed forward guidance -- the two-year Treasury at about 4.25% already reflects the likelihood of two Fed hikes later this year and early 2027. That yield also represents a meaningful pickup from the three-month Treasury bill, at 3.75%, and money-market funds such as the Fidelity Government Money Market fund, with a seven-day SEC yield of 3.32%.
A number of low-cost exchange-traded funds cover the one-to-three-year corner of the Treasury market. Among the largest are Vanguard Short-Term Treasury, iShares 1-3 Year Treasury Bond, Schwab Short-Term Treasury, and State Street SPDR Portfolio Short Term Treasury. They sport ultralow expense ratios of three basis points (0.03%), except the iShares ETF, which charges 15 basis points.
At the same time, shorter-term bonds provide nearly as much yield as lengthier maturities, and with significantly lower risk from rising interest rates. (Bond prices move inversely to interest rates.) A recent report from Janus Henderson shows the U.S. Treasury 1-3 Year index (the benchmark of the aforementioned ETFs) has a duration of about two years, compared with about six years for the U.S. Aggregate Index. (Duration is a measure of a bond's price sensitivity to interest rate changes.)
The firm calculates that a 79-basis-point rise in the U.S. Aggregate Index's yield would drop prices enough to wipe out its expected annual return. By contrast, it would take a 220-basis-point jump in the U.S. Treasury 1-3-Year Index to result in a nil return.
Janus Henderson advises sticking to short maturities, given its view that "the 50-plus year fixed income bull market," which brought long-term Treasury bond yields down from a historic peak of 15% in 1981 to 1% in 2020, is over.
Former longtime bond bull Lacy Hunt, the veteran chief economist at Hoisington Investment Management, also has reversed his previous position. He sees the equilibrium inflation rate shifting to a range of 3.5% to 4.5% from the benign 1.5% to 3.5% that prevailed from 1990 to 2020. That should give way to a more volatile interest-rate regime, he wrote in the firm's quarterly outlook.
In particular, the persistent rise in U.S. federal debt relative to gross domestic product could boost debt service costs, resulting in investors demanding a higher risk premium on Treasury securities, Hunt added. He noted the risk great powers historically have faced when debt-service costs exceed defense expenditures, an observation made last year by economics historian Niall Ferguson.
But by holding down its fed-funds rate target, whether by design or accident, the Warsh Fed is helping to limit the rise in Uncle Sam's interest expense. The Treasury under Scott Bessent continues to emphasize issuance of lower-cost short-term bills, including over $250 billion in August, according to a report from Wells Fargo.
At the same time, closed-end funds that use borrowed money would likely be hurt by eventual Fed rate hikes. Even so, a few CEFs that should be less affected by rising rates look attractive to Eric Boughton, portfolio manager and chief analyst at Matisse Capital, which manages funds of CEFs.
In particular, floating-rate CEFs should fare relatively well. Among them is the Eaton Vance Senior Floating-Rate fund, which traded at a 10.1% discount while yielding 7.80%. And while rate increases could hurt high-yield bond CEFs, he likes the Allspring Income Opportunities fund, which trades at over an 11% discount, near its widest over the past year, while yielding 10.19%.
In an interview, Boughton added that his Matisse Discounted Bond CEF mutual fund is maintaining a high 30% cash level to navigate a rising-rate environment and to take advantage of buying opportunities that can often occur in such circumstances.
The Fed eventually will raise its current fed-funds target range of 3.50% to 3.75%, which would effectively bring its policy rate in line with market expectations embedded in a two-year Treasury yield of 4.25%. Some leading Fed watchers, including those at J.P. Morgan and Goldman Sachs, see only one hike this year, while Morgan Stanley sees no increase in 2026 if inflation eases in coming months. In that case, higher-yielding short-term bonds would look even better.
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