Muni dynamics look brighter in 2026

What are your return expectations for Municipal Bonds in 2026?

With intermediate-to-long-term rates expected to remain range-bound, we believe income will be the primary driver of total return for bonds in 2026. For high-income earners, municipal bonds represent an attractive choice for non-qualified fixed income allocations, given their significantly higher tax-equivalent yields compared to taxable alternatives. To put this in context, assuming the highest federal tax rate of 37% plus the 3.8% Medicare tax, the tax-equivalent yield for the Bloomberg Municipal Bond Index is 6.10% compared to the Bloomberg U.S. Aggregate Index with a yield of just 4.35%. The tax-equivalent yield is what a taxable bond would need to earn to equal the yield on a tax-free bond. Municipals currently provide a 1.75% yield advantage over taxable with similar credit quality and duration. Over the past 10 years, this yield advantage averaged just 1.17%.

Over the past 20 years, high-yield (HY) municipal bonds have generally outperformed investment-grade (IG) munis. In contrast, HY munis lagged IG in 2025 despite a strong economy and favorable inflows into the high-yield space. The underperformance in 2025 was marked by idiosyncratic credit challenges among some of the largest muni high-yield issuers, including Florida’s Brightline Trains and Tobacco bonds, but we expect compelling opportunities in 2026. Demand should be supported by investors seeking to capitalize on the steep municipal yield curve and reasonable spreads — currently not at record tights — to earn taxable equivalent yields that could rival equity-like returns. 

Municipal bonds also continue to exhibit significantly lower default rates across all credit tiers, particularly in the non-investment-grade space. That said, achieving optimal return potential may require active management, including diversification of credit exposure and the ability to be tactical to actively manage the portfolio quality, sector allocation, and individual security selection. The relatively small size of the municipal high-yield market means that excessively large portfolios may struggle to diversify adequately, resulting in higher exposure to issuer-specific risk.

Municipal supply and demand dynamics in 2026

2025 was marked by municipal underperformance relative to most taxable fixed income sectors. Headwinds — including threats to tax exemption, federal funding concerns and Liberation Day dynamics — hampered demand for intermediate and long-term munis. At the same time, supply surged as issuers accelerated infrastructure borrowing after years of deferred spending following the Global Financial Crisis, when budgets and pension obligations took priority. Project costs have risen more than 30% since the pandemic, further increasing borrowing needs, and the Infrastructure Investment and Jobs Act (signed in November 2021) continues to encourage municipal issuance.

Supply has reached record levels for the past two years, exceeding $500 billion annually. We expect another record year in 2026 for these same structural reasons but anticipate investors will absorb this issuance. Demand strengthened in the second half of 2025 and should continue, supported by several factors:

• Attractive nominal yields translating into higher taxable-equivalent yields versus taxable fixed income
• Resolution of policy concerns that weighed on sentiment earlier in 2025
• Strong credit quality particularly at the upper end of the investment-grade spectrum
• Demographic trends favoring tax-efficient income solutions
• Portfolio rebalancing opportunities as investors seek diversification

Additionally, municipal separately managed accounts have experienced tremendous asset growth over the last several years. We expect that trend to continue as high-net-worth income-pursuing investors seek transparency, high-touch service, tax efficiency and customizable solutions, as well as the potential to add value in volatile market environments.

Municipal sectors that could perform well in 2026

We believe that the highest quality general obligation bonds, mostly backed by property taxes in affluent areas, and essential service revenue bonds (water/sewer/electric) will continue to perform well in 2026. However, the financial stability of some municipal sectors, specifically higher education and health care, may be negatively impacted by federal revenue reductions and general demographic changes.  

Within the higher education sector, colleges have been experiencing enrollment declines and federal scrutiny. This has been most pronounced among small liberal arts colleges, which tend to hold lower reserves and are more financially vulnerable to enrollment changes or revenue reductions. Within the hospital sector, Medicaid reductions and an aging population continue to be the primary concerns. However, the work requirements for Medicaid do not begin until 2027, and implementation of the provider tax rollback will not start until 2028.

Overall, municipal credit fundamentals remain relatively strong. However, the potential for credit stress in some portions of the municipal markets could underscore the need for active management to evaluate credit, manage exposures, and seize opportunities.