Compelling entry point for investment grade munis

Key Takeaways

• A mixture of significant U.S. Treasury volatility, lower liquidity, large supply outlook, and unfavorable seasonal factors have created a compelling entry point for investment grade municipal (muni) bonds.
• Most AAA muni-to-U.S. Treasury ratios – a measure of relative value in municipal bonds – recently touched their most attractive levels since 2023.

Muni yields remain elevated after early-April spike

During the week of April 7^th, U.S. Treasury yields surged (i.e., prices declined) based on tariff-induced uncertainty, pulling muni bond yields sharply higher in sympathy. The muni bond rout was exacerbated by seasonal and technical factors specific to the tax-exempt muni market – namely, massive new municipal bond issuance to start the year (and expected throughout 2025), sluggish demand typical of the spring season, and its lower liquidity profile overall.

As a result, most short-dated AAA muni bond yields touched their highest points in roughly 17 months. Beyond 5-year maturities, many AAA muni bond yields traded at their highest absolute levels since 2009. Most AAA muni-to-U.S. Treasury ratios – a measure of relative value in muni bonds versus similar-maturity U.S. Treasuries – hit their most attractive levels since 2023. Additionally, many munis offer a relative yield advantage over like-rated U.S. corporate bonds, after accounting for munis’ tax-exempt status.

However, as has been the case since the COVID-19 pandemic, U.S. Treasury volatility provided the primary driver for muni bond yields, as opposed to any underlying concerns specific to the muni bond sector. As U.S. Treasuries have re-discovered some stability, investment grade munis have reversed a portion of the yield spike. However, muni yields remain very elevated compared to the past 15 years and offer a compelling entry point. We also expect the seasonal factors that have pressured munis – low reinvestment activity and forced selling to fund April 15^th tax bills – to ease in the summer months and improve market function. Of course, munis will not be immune to any further bouts of volatility in the U.S. Treasury market, supporting neutral portfolio duration.

Muni credit outlook

Of all U.S. fixed income sectors, munis are often considered one of the most idiosyncratic. Issuers range from state and local governments, healthcare systems, airports, universities, and housing authorities, just to name a few. Each issuer navigates its own set of unique challenges – the health of its local economy, geography, demographics, and industry-specific risks for issuers like hospitals and airports.

Broadly speaking, investment grade munis have fared well in recent years, buoyed by the V-shaped economic recovery post-pandemic, enormous federal aid, conservative budgeting practices, and soaring real estate values. Some of these tailwinds are waning, especially the impact of $350 billion in federal aid distributed to municipalities nationwide. Those funds are largely exhausted. An increasing number of issuers are now tapping into the muni bond market to fund new projects, informing our expectations for historic muni bond issuance this year. Still, the muni credit landscape remains in good standing, particularly among investment grade issuers with credit rating upgrades far outpacing downgrades. Similar to our stance within U.S. corporate bond sectors, we still recommend a cautious and/or highly selective approach for investing in the high yield muni space.

Bottom line

Elevated starting yields, improved relative valuations, stable credit fundamentals, and abating seasonal challenges suggest investment grade munis now offer an attractive entry point for new investments