Why the Tariff Rollout Spooked the Muni Market

The recent volatility in the municipal bond market may be concerning for those who invest in munis for their stability, diversification, and tax benefits. Those muni characteristics still hold true—and concerns about tariffs and trade policy haven't derailed that, in our view. In fact, the recent volatility has pushed yields up to near historically high levels relative to alternatives and has created opportunities in municipal bonds, especially for higher-net-worth investors in our view.

Municipal bonds are issued by cities, states, and local governments and pay interest income that is usually exempt from federal and potentially state income taxes. As a result, the yields are often less than that offered by a comparable corporate or Treasury bond that is subject to income taxes. After adjusting for taxes, munis may yield more, especially for investors in higher tax brackets. We've long believed that higher-net-worth investors should consider munis for their credit stability, diversification, and potential tax benefits—and that's even more the case now.

On April 2nd, President Donald Trump announced new tariffs on nearly all goods imported into the U.S., rattling financial markets. Shortly after Trump announced the tariffs on April 2nd, yields for highly rated munis¹ declined along with U.S. Treasury yields. After bottoming on April 4th, muni yields moved substantially higher. They've since retreated from their highs but are still elevated relative to Treasury yields.

For the 10-year part of the muni yield curve, the change from April 4th to April 9th was the largest three-day move since the beginning of COVID-19 pandemic lockdowns in March 2020. The change resulted in a loss of roughly 5% for the Bloomberg Municipal Bond Index. Since then, total returns have recovered but are still negative for the year. Total returns for bonds are composed of changes in price and coupon returns. The coupon return has historically been the largest contributor to total returns. Over time, the coupon return builds upon itself and can offset short-term price declines.

Part of the reason why yields shot up so dramatically is because of the illiquidity of municipal bonds relative to other investments. There has been a considerable increase in the amount of selling pressure for munis, which has exacerbated the moves higher. The municipal bond market is much smaller than the Treasury or corporate bond markets and can therefore experience greater price fluctuations at times. Additionally, there were reports that some large muni exchange-traded funds (ETFs) faced redemptions and therefore had to sell positions to meet those redemptions.

We don't believe so. Credit conditions for most issuers has improved over the past five years. The odds of a recession have increased as a result of tariff policy but most issuers should have the financial resources to manage through a slowdown in the economy. If the recent moves were due to concerns about credit quality, we would expect to see spreads for lower-rated issuers increase more than higher-rated issuers but that largely hasn't happened. We believe this is mostly a technical (supply and demand) issue.

This is very difficult to handicap given all the uncertainty right now, but we would not be surprised if the increase in municipal bond yields settles down and muni yields relative to Treasuries move closer to their longer-term averages. A metric we commonly follow is the muni-to-Treasury ratio. It's the yield on a generic AAA rated muni relative to a Treasury of similar maturity before considering taxes. Muni-to-Treasury ratios have increased as a result of the selloff and are now well above their three-year averages. This should eventually attract crossover buyers and help settle things down. However, yields for municipal bonds may continue to remain volatile in the short run as the markets try to navigate trade discussions.

The selloff has created an opportunity, in our view. The yield-to-worst (the lowest yield that an investor can receive on a bond with a call option, barring default) for the Bloomberg Municipal Bond Index is close to 4.2% which is the equivalent of an over 8% taxable yield for an investor in a high-tax state like New York and California. We think that's fairly attractive relative to alternatives—especially considering that investors don't have to take a lot of credit risk to get those yields. For example, the yield-to-worst for the Bloomberg U.S. Aggregate Bond Index is 4.7%, which is fully taxable. We suggest most investors stick to a benchmark duration, but more tactical investors may want to consider adding to duration in the muni market at these interest rates. However, longer-term bonds are more volatile than shorter-term bonds and may experience higher volatility as the market navigates trade policy.

Prior to the tariff rollout, there had been concerns that the municipal bond tax exemption could be repealed to help pay for the cost of extending the 2017 Tax Cuts and Jobs Act (TCJA), which is scheduled to expire at the end of 2025. Some even speculated that those concerns were a contributing factor to the selloff. We disagree with that take. Those concerns existed prior to the recent selloff.

Additionally, our view has been, and remains, that the probability of the tax exemption being fully repealed is low. We believe it would do more harm than good and would hurt infrastructure spending and result in a tax hike for both low- and high-income individuals. Additionally, there has recently been support from some key House Republicans in favor of the preserving the muni tax exemption. On April 11th, key House Republicans sent a letter to the Chairman of the Ways and Means Committee cautioning against "any effort to eliminate or significantly curtail" muni bonds' tax exemption. Never say never, but we always believed it was a low probability that the exemption would be fully repealed and that probability has moved lower recently.

The volatility and selloff in munis is understandably unnerving but we would caution investors against taking a short-term approach. Although the move up in yields has resulted in losses, in the longer term it should bode well for total returns going forward because returns from coupons historically have been the primary contributor to total returns. Additionally, muni yields are very attractive relative to alternatives right now, in our view, and investors don't need to take on a lot of credit risk to get those yields. For most investors, we suggest sticking with a benchmark duration and staying up in credit quality by focusing the bulk of your muni portfolio on higher-rated issuers, like those in the AA/Aa or above categories for munis. A good starting point for most investors for duration is the Bloomberg Municipal Bond Index which has a duration of a little longer than six years.