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In the second quarter (Q2) of 2025, the US municipal bond (muni) market presents a compelling narrative for investors.

Robust demand for high-yield (HY) bonds during the first quarter of 2025 has shaped the municipal bond market's landscape, offering both opportunities and challenges that underscore the importance of active management and meticulous credit analysis. A demand driven by investors seeking higher returns in a high-interest-rate environment.

We believe that munis present a historically attractive opportunity for investors ...

However, significant volatility in rate markets has muted appetite in the space as geopolitical tensions and tariff policy become the front and center issue for market participants. We believe that munis present a historically attractive opportunity for investors able to navigate the complexities of credit risk and market volatility.

Increase in issuance

The first quarter of 2025 saw a notable increase in muni issuance, coming in over $115 billion, up over 15% from last year’s record-setting year in municipal supply. This created a headwind to relative performance, particularly in the investment grade segment, returning -0.22% in tax-exempt investment grade and 2.99% in taxable over the first quarter, which compares unfavorably to US Aggregate returning 2.78% and US Treasuries returning 2.92% during the same period.1,2,3 Corporate HY also slightly outperformed muni HY, returning 1.0% vs. 0.82%, respectively.4,5,6

Potential themes and trends

We believe the muni market is poised for a period of dynamic shifts and evolving trends. Investors should be prepared to navigate a landscape influenced by various factors, including economic policies, market volatility, and sector-specific developments.

The role of duration and yield curve strategies

In the current market, duration management is a key consideration for investors. With interest rates remaining volatile, short-duration bonds offer a more stable option for those wary of interest rate risk.

However, the steepening yield curve, often referred to as the "belly" of the curve, presents opportunities in mid-term maturities. Active managers are well-positioned to capitalize on these opportunities, adjusting their portfolios to capture attractive yields while effectively managing risk.

Economic fundamentals and market sentiment

Despite the noise around geopolitical tensions and economic uncertainties, we believe the muni market's underlying fundamentals remain on solid ground. As a domestic asset class, munis remain relatively insulated from some of the more severe effects of potential tariff policy shifts. Manufacturing moving to domestic production may benefit in the intermediate to long term.

The labor market has been resilient, with stable employment figures and tax collections up slightly from last year. These factors support a stable outlook for munis, particularly those with strong credit profiles. However, we believe investors must remain vigilant, as market sentiment can shift rapidly in response to new developments such as tariff and tax policy.

Regulatory and policy considerations

The regulatory landscape is another critical factor influencing the muni market. The potential for changes in tax policy, particularly regarding the tax-exempt status of munis, introduces an additional layer of uncertainty. While the base case scenario suggests that a full repeal of tax exemptions is unlikely, any changes at the margins could impact investor behavior and the value of these investments.

At the same time, initiatives under the Department of Government Efficiency (DOGE), spearheaded by Elon Musk, and the Trump administration's policies, are being reshaped and impacting certain sectors. We believe these aggressive cost-cutting measures have significant implications on the municipal market, which benefits from federal funding; some of the most affected sectors include hospitals, education, and federal lease-back bonds.

Sectors to watch

We believe several sectors should be monitored as investors navigate the opportunities and risks associated with today’s market volatility, fueled by tariff turmoil and trade wars.

Education

While President Trump’s order calling for the dismantling of the Department of Education has complex implications, we believe it may result in increased muni issuance, which could present new opportunities as well as risks for investors.

  • Abolishment of the Department of Education?
    The Trump administration's executive order is expected to transfer authority over education to states and local communities, potentially disrupting federal funding streams for public education. The impact may be more severe on colleges and universities, as a pullback in federal grant programs and loans may result in institutions needing to rely more heavily on tuition revenue and debt issuance to finance their operations and capital projects.
  • Taxability of endowment funds
    The proposed increase in the taxability of higher education endowment funds is another critical factor to consider. A potential hike in excise taxes on endowment income could strain the financial resources of colleges and universities, prompting them to seek additional funding through munis. This trend may result in increased issuance of bonds by higher education institutions, providing investors with opportunities to support these entities while managing the associated risks.
  • School choice policies
    The Trump administration's commitment to expanding school choice for students, mainly through support for charter schools and publicly funded education institutions, is reshaping the educational landscape. These policies aim to empower parents and students by providing more educational options, which could lead to increased demand for munis to finance new charter schools and educational programs. Investors should consider the potential growth in this sector and the opportunities it presents.

Healthcare

We believe tax policy changes may also impact the healthcare sector. Potential cuts to Medicaid spending could put further pressure on hospitals, particularly smaller hospitals that do not benefit from the realization of economies of scale.

Final thoughts

The outlook for munis in Q2 may continue to be volatile as treasury rates remain rangebound. We believe this will create opportunities for prudent investors adept at managing credit and duration risk mitigation strategies. Investors should expect to navigate a dynamic environment characterized by resilient economic fundamentals, DOGE initiatives and government spending, regulatory uncertainties, and sector-specific opportunities. Finally, by focusing on credit analysis and leveraging active management strategies, we believe investors can position themselves to capitalize on the opportunities while managing the inherent risks.

1 Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD.
2 Bloomberg U.S. Aggregate Index, March 2025.
3 Bloomberg U.S. Treasury Index, March 2025.
4 Bloomberg U.S. Corporate High Yield Bond Index, March 2025.
5 The Bloomberg US Municipal Index is a flagship measure of the US municipal tax-exempt investment grade bond market.
6 Bloomberg U.S. Municipal Index, March 2025.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Indexes are unmanaged and have been provided for illustrative purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

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