Last week’s big decline in interest rates feels a lot more real than the similar move at the beginning of the year. If so, what does it mean for public funds investors?

The rally in bond prices boosted the returns on our 1–3-year model portfolio ahead of cash returns for the first time in several years. The model 1–3-year portfolio returned 1.16% for the month which equates to an annualized return of more than 13%. See the Dashboard here. The rally boosted the one-year return on the portfolio to 5.75%. For the first time since the pandemic the longer-duration portfolio outperformed cash/LGIP/money funds.

Meanwhile the yield to maturity of the model declined to 4.74%. If the Federal Reserve cuts rates by even a modest amount later this year/into next year the yield to maturity would be particularly attractive.

The impact of the bond market rally on LGIP and money fund yields has not been realized—yet. On Friday, the yield of the PFII Prime LGIP Index was 5.43% vs. 5.44% at the end of June. The yield on the PFII Government Index was 5.27%, also only one basis point off the June high.

Overnight investment rates have not budged in the rally. Repurchase agreement rates reported by the New York Fed for all of July averaged 5.33%, the same level reported for Friday. Over the month one-year Treasury Bill yield declined by 80 basis points. (It declined further today.)

As we noted in a recent LinkedIn post fund managers on average have maintained a short weighted average maturity in the face of this rally. In effect they elected to hang on to the highest available short-term yield as long as possible.

LGIP (and money fund) yields will fall rapidly when the Fed eases monetary policy. How rapidly depends on the structure of the portfolio—how much liquidity it maintains and its weighted average maturity. In the first days after a cut, the advertised (7 day) yield would move hardly at all because its calculation includes yields for pre-cut days. By the end of the 30-day period, much or all of the portfolio would have been reinvested in post-cut yields.

We simulated this for our model LGIP portfolio with a sample of results on the following chart. Each line represents the forecast for a model portfolio with a different WAM (40 or 50 days), and different one day liquidity (10%-30%)

A portfolio with a shorter WAM and more liquidity would yield between 25 and 35 basis points less than immediately before the cut. Why is the gap more than the 25-basis point cut? Because reinvestment rates are likely to reflect a market expectation of additional cuts in the near term.

There is a message of caution here: LGIP and money fund yields represent a look in the rearview mirror, and especially when markets move, they will not represent the yield to be earned over the coming days/weeks.

The cost of yield protection has ballooned. At the end of May if an investor chose to lock in the yield for a one-year period they would have paid a price equal to about 18 basis points. That was the difference between the yield on the PFII Prime Index (5.44%) and a one-year Treasury bill (5.26%) and could be considered the price an investor would have to pay for a fixed rate over the variable rate LGIP. By Friday that cost had ballooned to 1.06% (the difference between the Prime Index yield and the T/ Bill yield on the accompanying chart).

Looking back, in May the “cost” of protecting yield was cheap at 18 basis points. Whether it makes sense at current yields depends on your view of how much and how fast fast short-term yields will change from here.

(To be fair, the choice of a variable or fixed rate is more complicated than this, but simplifying it serves to illustrate that “yield protection” has a cost, much like insurance.)

This is not simply a matter of reading the tea leaves—or, as many do, analyzing the Federal Reserve’s “dot plot” of the forecast for Federal Funds.

While investors obsess over Fed policy as the main driver of interest rates, sometimes markets do the job instead of the Fed. We saw this in the spring of 2022 when investors drove interest rates sharply higher even before the Fed began to tighten. And we see it again now as the market is easing—pushing down rates—though the Fed has not moved.

Credit risk has been priced higher. Concern about whether the economy might be heading into recession has caused investors to pull back from credit investments (commercial paper, negotiable CD, and corporate bonds), driving yield spreads wider and increasing the cost of credit insurance. This is illustrated on the following chart of the cost of insuring a basket of investment grade corporate bonds for five years.

With this new caution about taking on risk, credit instruments are likely to under-perform similar duration Treasuries—a different dynamic than we saw in recent quarters. The PFII model 1–3-year portfolio consists of 60% Treasuries, 30% investment grade corporate bonds (and 10% cash). The model portfolio one-year return of 5.75% is a blend of return on Treasuries (5.42%) and return on credit (6.56%), with credit boosting the overall return by 33 basis points. This happy force is no more. In the short run corporate holdings are going to be a drag on return compared to the return of a risk-free Treasury portfolio.

In the LGIP space, however, wider spreads should have minimum impact on "return" since investments are short-term. But wider spreads would increase the advantage of investing in prime funds.

* Corrects reference to the model portfolio in the penultimate paragraph.