Make your short-term bond investment work smarter

Savers are increasingly worried about the prospect of rising interest rates, but with bank deposit rates close to zero, they’re searching for short-duration investment products that minimize interest rate risk without sacrificing income. If this is your goal, it’s worth considering a “crossover” option: short-term strategies that combine both taxable bonds and tax-exempt municipals.
Many different types of short-term products have been introduced to the marketplace during the Federal Reserve’s historic low-rate regime, some highly sophisticated and technical and some more traditional. The lowest-duration (lowest interest rate exposure) products include money market funds and floating-rate note funds. Savers looking for additional yield might opt for a short-term municipal bond fund or perhaps a short-duration high yield fund. A third and somewhat new approach takes a slightly different angle by employing a crossover approach in which the portfolio would include investments in both taxable and tax-exempt bonds, depending on where there’s more value.
Here are five reasons to consider it:
1. Tax-exempt income. The value of a tax-exempt dollar has increased significantly as income tax rates have risen. In crossover strategies, to meet IRS guidelines governing the pass-through of the tax-exempt income generated, the fund would need to have a minimum of 50% in tax- exempt municipals at all times.
2. The chance to capitalize on relative value opportunities between taxable and tax-exempt bonds. For example, at current valuations, we estimate that the best balance for a short-term portfolio is about 20% taxable bonds and 80% munis. But the relative attractiveness of taxable and municipal bonds fluctuates over time, so a short-term portfolio with the flexibility to vary its asset allocation accordingly can take advantage of dislocations in either market and pass those cost and yield benefits along to investors.
3. The chance to exploit muni-market inefficiencies. As we’ve pointed out often in the past, the municipal market is a highly idiosyncratic marketplace, prone to pricing anomalies and information gaps. Intensive research and active management can uncover attractive opportunities in this market through up and down interest rate cycles.
4. Broadening the opportunity set via taxable bonds (see chart below). The taxable universe offers access to sources of yield and diversification that can’t be found in the muni market, such as investment-grade foreign government bonds, private-sector corporate bonds and asset-backed securities, among others.
5. A focus on after-tax total returns, not just income. In other words, at any given level of yield, think in terms of tax efficiency, seek out bonds that offer the best value relative to their peers and, by implication, more likelihood of capital appreciation.