Municipal Bonds: Navigating Policy Shifts, Resilient Yields, and Tax-Exemption Crossroads

Recent volatility in the municipal bond market has understandably raised concerns among investors. Despite these fluctuations, we believe the fundamental credit quality of municipal bonds remains robust, and current conditions may present strategic opportunities for long-term investors. 

Recent Market Developments 

In early April, bond yields followed the lead (and then some) of the US Treasury yield reversal. The 10-year Treasury yield ranged from a low of 3.87% to a high of 4.45%, intra-day, April 9th.  As a result, selling pressure in the municipal market increased, with market participants seeking liquidity, culminating in some of the biggest declines in the muni market in the last 30 years. 

This sharp sell-off has erased gains accumulated over months, catching many market participants off guard and prompting a reassessment of risk in what is traditionally viewed as a safe-haven asset class. 

Several factors have contributed to this volatility: 

• Tariff Announcements: The Trump administration’s implementation of greater than expected tariffs has heightened market uncertainty, leading investors to seek liquidity and adjust portfolios accordingly. These tariffs, aimed at reshaping global trade dynamics, have sparked fears of inflationary pressures and economic slowdown, prompting a broader flight from everything except treasuries. 

• Technical Imbalances: An increase in new municipal bond issuances, up 15% in the first quarter compared to the same period in 2024, has outpaced demand, creating supply-demand mismatches. This surge in supply—driven by municipalities rushing to fund infrastructure projects ahead of potential policy shifts—has overwhelmed a market already grappling with shifting investor sentiment. 

• Liquidity Constraints: Dealers have reduced market-making activities due to challenges in hedging risks amid market volatility, further straining liquidity. This pullback reflects a broader trend of caution among financial intermediaries, as heightened uncertainty makes it costlier to hold inventory, exacerbating price swings. 

Fundamental Strength and Outlook 

Despite recent price declines, the underlying financial health of many municipal issuers remains solid. State and local governments have maintained healthy cash reserves and demonstrated fiscal prudence, bolstered by strong tax revenues in recent years and federal aid from pandemic-era stimulus programs. This resilience positions them well to manage economic uncertainties. Managers we have spoken to emphasize that after years of conservative budgeting, municipal credit fundamentals are entering this period of uncertainty in strong form. They note that municipalities benefit from the essentiality of services provided—such as water, power, and education—which grants pricing power and demand inelasticity, enhancing budgetary flexibility through both expense cuts and revenue-raising measures. Historical precedent supports this view: the National Association of State Budget Officers reports that over the last 40 years, cumulative state revenues declined in only four years, with 33 states raising taxes or fees during the GFC. 

Additionally, tariff policy should not significantly affect municipalities directly, as their revenue streams—primarily property, sales, and income taxes—are largely insulated from international trade disruptions. However, prolonged economic weakness could indirectly lead to softer tax receipts, particularly in regions reliant on trade-sensitive industries. The new administration’s flurry of executive orders and policy proposals adds further uncertainty. While definitive changes remain elusive, potential impacts are under scrutiny.  

For instance, the elimination of tax-exempt borrowing has been floated as a way to offset the extension of the Tax Cuts and Jobs Act. Though no direct proposal has emerged, managers remain confident that the tax exemption will endure, given its critical role in funding infrastructure nationwide—higher borrowing costs would effectively act as a tax increase across all regions. If enacted, any change would likely apply only to future issuances, preserving the tax-exempt status of existing bonds due to significant legal hurdles. Peripheral segments like corporate-backed bonds or stadium financings might face greater risk of losing exemptions. 

Looking ahead, several factors may support the municipal bond market: 

• Attractive Tax-Equivalent Yields: Current municipal bond yields offer compelling tax-equivalent returns, particularly for investors in higher tax brackets, and every 10bps of incremental muni yield raises the tax-equivalent yield 17bps for the highest earners. 

• Valuation Opportunities: Municipal-to-Treasury yield ratios are at levels not seen since October 2023, indicating that municipals are relatively cheap compared to Treasuries. The 10-year sits at 79%, while the 30-year is at 94%, versus averages of 60-65% since 2022. 

• Seasonal Demand: The approaching summer months typically bring increased reinvestment flows, which could bolster demand for municipal bonds. Historically, June and July see coupon payments and bond maturities redirected into the market, a pattern that could stabilize prices if investor confidence rebounds. 

Strategic Considerations for Investors 

Given the current market dynamics, we continue to believe that maintaining a strategic allocation to municipal bonds can offer diversification benefits and potential for tax-advantaged income. The asset class’s low correlation with equities and its relative stability over long horizons make it an appealing anchor in turbulent times.  

Investors may consider the following approaches: 

• Active Management: Engaging with active managers who can navigate market volatility, identify undervalued securities, and capitalize on dislocations may enhance portfolio resilience.  

• Credit Quality Focus: Prioritizing investments in higher-quality municipal issuers—such as general obligation bonds backed by taxing authority or essential-service revenue bonds—can help mitigate credit risk amid economic uncertainties. AAA-rated issuers, while yielding less, offer a safety buffer as default rates remain near historic lows (0.1% annually, per Moody’s). Managers we have spoken to highlight large, well-run municipalities, with revenue diversity and strong liquidity access, are particularly resilient. 

• Duration Management: Adjusting portfolio duration in response to interest rate movements and economic outlook can aid in managing interest rate risk. With the Federal Reserve signaling a cautious stance on rate cuts in 2025 amid tariff-driven inflation concerns, shorter-duration bonds (e.g., 5-7 years) may provide a balance of yield and protection against rising rates. 

TwinFocus Conclusion. 

While recent market volatility has impacted municipal bond valuations, the fundamental credit quality remains strong, underpinned by fiscal discipline and structural safeguards. Current conditions may present opportunities for investors to achieve attractive, tax-advantaged returns through strategic allocations to municipal bonds. By leveraging active strategies, focusing on quality, and aligning duration with macroeconomic trends, investors can position themselves to weather near-term turbulence and capitalize on the market’s long-term potential. 

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