Municipal Bonds: Mid-Year 2025 Outlook

Coming into the year we expected the municipal market to be characterized by a tale of two halves, with concerns about the tax bill dominating the first half of the year and the market adjusting over the second half of the year. We were correct that tax policy would take center stage in the first half of the year.

The "One Big Beautiful" tax bill, which is currently working its way through Congress, was largely a non-event for most of the muni market despite initial concerns that the muni tax exemption could be on the chopping block. The most recent version of the bill keeps in place the current tax brackets and doesn't restrict or remove the muni tax exemption. It's essentially status quo from a tax perspective but it could impact credit quality of issuers in certain sectors longer term. For example, the bill would make cuts to Medicaid and could shift more of the cost of Medicaid to states, thus reducing their financial flexibility to meet debt service.

Even though the bill keeps in place the tax exemption, there were concerns that the bill would limit the ability of issuers to issue tax-exempt debt, which contributed to a rush of issuance during the first half of the year. Issuance is relevant for performance because total returns are influenced by supply-and-demand dynamics. Additionally, higher inflation has also contributed to an increase in issuance recently. Municipal bonds are often used to fund infrastructure projects, which are now more expensive due to higher inflation. In fact, the amount of munis issued in 2024 was the highest since at least 2010 and 2025 is on pace to exceed that amount.

We would not be surprised if issuance moderates over the second half of the year, now that it's highly likely that the muni tax exemption won't be repealed. However, it will likely remain high for the rest of the year given higher infrastructure costs. Partly as a result of the surge in issuance, munis were the worst-performing asset class among all the major sectors we track during the first part of the year. Going forward, if issuance moderates, as we expect it will, total returns should recover.

Although munis have had a rough first half of the year, we believe they remain an attractive investment option for investors in higher tax brackets. Simply put, the two main tenets of munis—tax-advantaged income and generally high credit quality—are still intact.

The yield-to-worst (YTW) for the Bloomberg Municipal Bond Index, which is a broad basket of munis, is 4% as of June 25th. It's important to note that this is an index of bonds and includes both short, intermediate, and longer-term bonds as well as some higher- and lower-rated issuers. While 4% may not seem attractive compared to other fixed income investments, it's because interest from municipal bonds is usually exempt from federal and potentially state income taxes. This is unlike other fixed income investments. After adjusting for the impact of taxes, munis will likely yield more than corporates for investors in the 22% and above federal tax brackets.

During the second half of the year, we expect the Federal Reserve to cut rates one or two times depending on how the economy evolves. This is important for investors who are holding a large portion of their fixed income portfolio in shorter-term bonds. Once the Fed starts cutting rates, yields for those short-term investments will likely fall and when those investments mature, investors could be faced with lower short-term yields. For longer-term munis, we believe yields could move lower over the second half of the year if the economy slows.

Additionally, moving out the yield curve looks more attractive now than it did earlier this year because investors are being better compensated for taking on additional duration risk. The slope of the two-year/10-year AAA muni curve is roughly 60 basis points. In other words, a 10-year AAA rated muni yields 60 basis points (0.60%), more than a two-year AAA rated muni.¹ That's the steepest since August 2022 and currently steeper than the two-year/10-year Treasury yield curve.

The other tenet of the muni market, high credit quality, remains intact and doesn't appear likely to deteriorate substantially any time soon. For 17 straight quarters, Moody's Investors Service has upgraded more municipal issuers than it has downgraded. This has been the longest streak of upgrades relative to downgrades since the end of 2008. As a result of the streak of upgrades relative to downgrades, the percentage of munis that are either AAA/Aaa or AA/Aa, the top two rungs of credit quality, is near the highest in nearly two decades.

This is important for two reasons. First it means that investors can get what we believe are attractive yields without having to take on too much credit risk. Usually, investors have to take on extra credit or interest rate risk to get higher yields but that isn't the case with munis today. Secondly, if the economy and revenues slow, it means that more issuers on average have greater financial flexibility to weather a slowdown. High financial flexibility usually coincides with a high credit rating.

We don't expect credit quality to substantially deteriorate during the second half of the year but we would not be surprised if the pace of upgrades relative to downgrades slows. States and municipalities face a number of potential headwinds, such as an economic slowdown due to tariffs, a slowdown in home price growth, a slowdown in sales tax revenues, Medicaid cuts, and efforts to curb immigration and the workforce. Additionally, 39 states made notable tax changes coming into the year, which can compound budget issues². The pace of change for tax revenues remains positive but is down from the peaks in 2021 and 2022.

Although municipalities face many risks going forward, the good news is that they're mostly in good financial shape now and have built up sufficient reserves to withstand a revenue slowdown. For example, Standard and Poor's estimates that projected fiscal 2026 reserves are sufficient to close a 10% revenue decline for 34 states. Strong reserves, "coupled with great flexibility to reduce expenditures, means that most states are generally in a strong position to withstand a relatively substantial decrease in revenue in the short term" according to S&P.

The second half of the year may be characterized by high volatility as the market attempts to digest the impact of federal policies, a potential slowdown in the economy, and other issues. This could result in even more attractive opportunities in the muni market but those opportunities may be fleeting. For example, shortly after the April tariff announcement, municipal bond yields shot up much more than Treasuries of similar maturities. This resulted in a very attractive buying opportunity but since then yields relative to Treasuries have moved back to where they were prior to the tariff announcement.

Given the potential for higher volatility in the second half of the year, we continue to suggest that most investors focus on keeping average portfolio duration at benchmark-or-below levels (we use the Bloomberg Municipal Bond Index for a muni benchmark, which currently has an average duration of about six and a half years). For the average muni investor, a duration of about six years provides an attractive balance of risk and reward, in our view.

We also think that higher-rated issuers are more attractive than lower-rated issuers on average. Although credit conditions are generally favorable, yields for lower-rated issuers aren't that much higher than yields for higher-rated issuers. Therefore, we do not think taking too much credit risk makes sense right now.