After stormy weather, the sun may be shining on municipal bonds

Battered by negative headlines, policy threats, record issuance and tepid investor demand, the municipal bond market has weathered multiple storms in 2025, resulting in substantial underperformance. The S&P Municipal Bond index returned just 2.67% through the first three quarters, while the Bloomberg US Treasury and Aggregate indices returned 5.35% and 6.88%, respectively. The staggering underperformance was driven by $434 billion of new issuance through the first three quarters, 34% higher than the average of $323 billion over the past five years, and investor concerns that ultimately did not materialize.

In our view, the dark clouds have largely cleared and the tax-exempt market — particularly bonds with longer-dated maturities at the long end of the yield curve — is set to meaningfully outperform the broader fixed income markets. To understand why, we must look at what caused the negative investor sentiment in the first place.

Plenty of concerns early The year began with a series of negative headlines that shook investor confidence. Devasting wildfires in California caused prices to fall on bonds issued by some utilities in the region, most prominently Los Angeles Department of Water and Power, and revived concerns about the risks of climate change on municipal credit. The new Trump administration began floating the idea of potential cuts to federal support for state and local governments, including FEMA and Medicaid, and questioned the not-for-profit status of some universities, all of which would negatively impact municipal credit. Additionally, some media outlets prominently featured negative stories about the muni market related to pricing transparency and idiosyncratic risk connected to some high-yield issuers.

But the most destabilizing threat was the uncertainty surrounding the expiration of the Tax Cuts and Jobs Act of 2017 and the work on legislation to extend the tax cuts. Early proposals by the House Ways and Means committee suggested reducing or eliminating the municipal bond tax-exemption as a way of funding the tax cut extension. Such a move would have severely impaired state and local governments and undermined the tax-exempt market’s foundation. Fortunately, the final version of the replacement legislation, the One Big Beautiful Bill Act, preserved the muni tax exemption, allowing the market to breathe a collective sigh of relief.

Back to the basics Amid this whirlwind, investor concern was understandable. But now that these concerns have largely faded, we are starting to see performance bounce back. As investor focus has begun shifting to traditional measures, such as credit quality, relative value and trading technicals, we expect this rebound in performance to continue for the following reasons:

• Credit remains robust Many sectors benefit from resilient, and in some cases monopolistic, revenue streams. By and large, states hold ample reserve funds and are well positioned to navigate evolving federal policies, including Medicaid reform. This is a positive development for an asset class that is considered high-quality and historically has significantly lower default rates compared to corporate bonds at every level of the credit quality spectrum.
• Attractive relative value In the current market landscape in which many asset classes appear overvalued, munis stand out as fairly priced, with taxable-equivalent yields at levels not seen in more than a decade. For top tax-bracket investors, the current yield pickup of the Bloomberg Municipal Bond Index relative to the yield on the Bloomberg Aggregate Bond Index is 180 basis points, well above the 10-year average of around 115 basis points.
• Technicals tailwind After three quarters of record new supply, issuance is expected to wane through year-end, which should provide a significant tailwind for the market. Additionally, the long end of the municipal bond AAA yield curve is historically steep, presenting an attractive opportunity to invest in longer-duration muni products. We believe this, in combination with the dynamics described above, has created one of the most attractive buyer's markets in recent memory. In fixed income in general, starting yield can be an indicator of total return potential. With taxable-equivalent yields elevated, muni investors could be setting themselves up for strong performance ahead.